Whether you are an entrepreneur or an angel investor, the topic of convertible note vs. equity impacts you. For the most part, startups favor convertible notes and angels prefer equity, but which one is the right choice for your startup?
Here, we review the benefits of each.
Convertible debt was most commonly used as a bridge loan between two rounds of financing. For example, if you raised $1,000,000 in series A funding and you were going to raise $5,000,000 in a series B round, you might use a bridge loan if you needed $250,000 until the funding was completed. However, convertible debt has recently become a popular seed round financing instrument.
Here is a basic overview of how convertible notes work:
An angel investor invests $200,000 in a startup as a convertible note.
The terms of the note are a 20% discount and automatic conversion after a qualified financing of $1,000,000.
When the next round of funding occurs at $2,000,000, the investor's note will automatically convert to equity.
In this scenario, let’s assume the shares were priced at $1.00. Since there is a 20% discount, the investor can use that $200,000 investment to purchase shares at the discount rate of $.80 each, instead of the $1.00 price that other participants in the current funding round will have to pay. That gives the initial investor 250,000 shares for the price of 200,000, which is a 25% return — not bad.
Caps can also be added to convertible debt. A cap sets a limit for how much the startup can raise before your shares stop getting diluted. It doesn’t value the convertible note, but it sets an upper limit. So in the example above, if the pre-money cap was $5,000,000, you would still get a discount of 20% up to that amount. If the startup raised at a valuation over $5,000,000, then the discount would increase to offset the additional dilution that was occurring. When you add a cap, the math gets a little trickier, as it can change with different funding scenarios.
While a convertible note might be a little confusing to calculate, equity is a breeze. The startup is assigned a pre-money valuation and a share price is determined. When you invest, you know exactly what the terms are and how many shares you will own in that round.
Here's how it works:
The startup has a pre-money valuation of $1,000,000 with 1,000,000 shares outstanding. This puts the share price at $1 per share.
An angel investor makes an investment of $200,000 and receives 200,000 shares.
The post-money valuation is $1,200,000 and the new investor owns 16.6% of the company.
Why Convertible Debt?
If equity is so much easier to understand, why are convertible notes becoming more common in the startup community? Here are four reasons why:
1. Valuation: Determining the valuation of a startup is hard, especially if the startup is pre-revenue and only in the idea phase. How do you put a value on the potential of the team/idea? It is easier for a startup to put off that question until they have some traction and social proof. Convertible notes are attractive for a startup because it delays this issue. While adding a cap essentially prices the round, it does leave a range of options, so it is more attractive to the startup.
2. Cost: Convertible note term sheets are less expensive than term sheets for equity, although with new standard term sheets that cost difference is starting to diminish. Sometimes it doesn’t make sense to pay the additional legal costs for closing the equity round if the funding increase is less than $250,000.
3. Speed: The equity valuation conversation can take weeks of negotiating before terms are agreed upon. With debt, the terms are simple, easier to negotiate, and you can close on them pretty quickly.
4. Control: When a startup raises debt, the founders retain the majority of the voting stock in the company. That means when it comes time to make a decision that requires a vote, you will be in a better position to execute your plan. You might get a broad seed request with a larger debt investment, but typically in a seed stage offering, you won’t have to worry about that.
Every situation calls for a different type of financing structure. It is important that each benefit is weighed to see what is right for the startup and for the investor. As a startup, you want to give your early investors good terms because they are helping you accomplish your goals. As an investor, you want to make it as easy as can be for the startup because they need to be focusing on building the business and not revising terms for an offering.
Image courtesy of Flickr, Marshall Astor - Food Pornographer