Convertible notes are a popular form of alternative debt financing for start-ups (particularly, seed stage businesses) who may struggle to raise working capital from traditional financing sources. However, it is important for founders to understand the benefits and drawbacks of convertible notes to determine whether they are the best form of financing for their business.
What is a convertible note?
A convertible note is a type of debt funding (i.e. a loan) that usually converts into equity (i.e. shares in a company) if certain events occur, such as:
- a successful investment round (capital raise); or
- the sale of the company or an initial public offering of shares (exit event).
If a capital raise or exit event do not occur, the loan amount (plus interest) is paid back to the investor (the “convertible noteholder”) on the maturity date.
Why use a convertible note?
The main issue with capital raising for start-ups is that it can be difficult for founders and investors to agree on a valuation for a company, especially for seed stage companies. By raising working capital through convertible notes, the start-up can delay valuing the company until a future capital raising round that is sufficiently large to justify the cost and effort in valuing the company.
When a capital raising round subsequently occurs and the total share capital in the company is then valued, the convertible noteholder will be issued shares in the company based on the amount they advanced to the company and for an agreed conversation price, which is usually a discount on the market value for those shares.
Convertible notes are also straight forward documents which minimise the need for founders and investors to undertake a costly negotiation process.
What are the main features of a convertible note?
- Valuation cap – the valuation cap (also known as the conversion cap) is the maximum price at which the loan amount will convert to shares in a company. The lower valuation cap, the more equity the noteholder will acquire in the company at the next capital raising round. For example, assume a company issues a convertible note to an investor with a valuation cap of $2 million. Should the company’s valuation at the next capital raising round be $4 million, the investor’s convertible note will convert into equity at the valuation cap price of $2 million. Therefore, the investor will receive twice the amount of equity for their investment. Therefore, it is important to select a valuation cap in the convertible note that is likely to be lower than the valuation of the start-up at the time of the next capital raising round. If not, then the noteholder will receive less shares in return for their investment.
- Interest rate – convertible notes will accrue interest on the loan amount until it converts to equity or it is repaid on the maturity date. The convertible note interest rate can range from 2 to 15 per cent.
- Discount – convertible noteholders are usually offered a discount on the market value for shares in a company to reward them providing an unsecured loan to a start-up, which are perceived to be high risk investments. Discount rates range from 2 per cent to 30 per cent on the market price for the shares.
- Maturity date – convertible notes have a maturity date, when the loan amount is due and payable to the noteholder, unless the convertible note has already converted to equity.
What are the advantages to using convertible notes?
There are numerous benefits for founders to use convertible notes to raise working capital, such as:
- Less complex – convertible notes can be quicker and simpler to enter into compared to direct equity investment. For example, there is no requirement to prepare subscription agreements and shareholders’ agreements when issuing a convertible note.
- Attractive – convertible notes are attractive investments for seed investors, venture capital firms and angel investors, who are willing to accept the risks associated with early stage start-ups. In exchange for investing early, the start-up grants the investor a discount on the future market value of the shares.
- Pre-valuation investment – start-ups are difficult to value (particularly, at the pre-revenue stage). Using a convertible note means founders will still receive the working capital required from an investor but the valuation process will be deferred until an agreed maturity date or future capital raising round at which point it may be easier to value the business.
- Voting power – noteholders do not have shareholder rights, such as voting rights. Therefore, the founders will maintain control over voting at board or shareholder meetings until the convertible note converts into equity.
- Flexibility – depending on the drafting, convertible notes can provide founders with substantial flexibility to treat the sum advanced as either debt to be repaid by the business or have the debt convert to equity at the next capital raising round or an exit event.
What are some of the drawbacks of using convertible notes?
For founders and investors, convertible notes do have several disadvantages:
- High risk – convertible notes can be high risk for investors because a cash hungry start-up may face future difficulties raising working capital resulting in the liquidation of the start-up and the loss of investment amount.
- No control – a noteholder has no voting rights in relation to important business matters, such as whether there will be a future capital raise or the share price at a future capital raising round. The valuation of the business will be determined by future investors and the founders, and the noteholder has no role to play in negotiating the share price. If there is no valuation cap, the founders may push for a high valuation of the business whereas the noteholders will want a low valuation to secure more equity in the business.
- Debt – a convertible note is classified as a debt which must be repaid (either by repaying the debt or the note converts into equity). For investors, convertible notes are usually unsecured loans to the start-up.
It can be difficult for unproven start-ups to secure funding for working capital. Traditional financing (such as loans or share subscriptions) may not be available to a start-up because the start-up cannot be valued, or the start-up is still at the proof-of-concept stage.
Convertible notes are a popular form of debt financing when founders and investors cannot determine the value of the start-up. Convertible notes allow an investor to convert the sum advanced to the start-up into equity in the business when a specific milestone has been reached, such as a capital raising round or exit event.
Convertible notes are one of many financing options available to founders to secure working capital and therefore it is important to understand their benefits and drawbacks. It also important that founders and investors also understand the implications of valuation caps and discount rates on the capacity of the business to raise future working capital and the value of the noteholder’s investment in the business.
In a future blog, we will be discussing other financing options available to start-ups, such as SAFE notes.
If you require advice in relation to whether convertible notes are right for your business, call Vault Legal today on 1300 002 212 or email us at firstname.lastname@example.org.
Key words: capital raising, convertible note, equity, shares, start-up and working capital