Think of a promising startup itching to grow its wings and showcase its brilliant product to the world. One of its pressing considerations in its early stages would be raising capital through external funding. Now, imagine a savvy investor who has conviction in the aims and causes of the said startup and hopes to gain something back from their investment.
The mode chosen by the startup and the investor to have capital invested in the company has significant implications for both parties. In this post, we’ll compare two of the most frequently used methods — convertible notes and equity — and lay down the pros and cons of each for your consideration.
What Is a Convertible Note?
A convertible note is a short-term debt that eventually converts into equity. Convertible notes operate as loans and are typically issued in conjunction with future financing rounds.
When an investor loans money to a startup under a convertible note, instead of receiving the principal sum back with the accrued interest, the investor gets shares of preferred stock as part of the startup’s initial preferred stock financing.
By putting a ceiling on the conversion price of the note, a valuation cap permits investors to share in any significant increase in the value of the company after their investment.
Conversion into Equity
When a conversion note gets issued, it automatically converts into shares of preferred stock when a startup raises a round of series A funding. The terms of the note dictate the share prices. If there’s no conversion, they also state the balance due along with the interest and the due date.
To compensate for the risk taken, startups offer a valuation discount to investors. Let’s illustrate this by way of an example.
Suppose an investor injects a $100,000 convertible note in a startup with a 10% discount rate. Subsequently, the company gets a $1 million valuation, with 1 million shares having a per-share value of $1. In the absence of a discount, the $100,000 convertible note would convert to 100,000 shares. However, with the 10% discount rate, the note is converted into 111,111 shares because the share price is reduced to $0.9 at conversion.
Under an equity investment, the investor receives shares in the company at the time of their investment.
For growth companies where cash flow is difficult to predict, it’s challenging to forecast repaying debts. Most entrepreneurs, therefore, take issue stock in the company.
A General Comparison
Convertible notes have made variable pricing possible. A convertible note allows entrepreneurs and investors to customize the terms as they see fit. The flexibility to select the key terms like discount rate, maturity dates, and interest rates enables creating an agreement that best suits the parties’ needs.
Convertible Notes vs. Equity Comparison for Companies
- Speed and Expense: A startup can complete a convertible note transaction in a couple of days — incurring modest legal fees in the process. Moreover, issuing shares of preferred stock is a complex process and can take weeks to negotiate, and the incurred legal costs can also be considerably high.
- No Running Costs: A startup wouldn’t have to make monthly payments by using a convertible note. The capital can be utilized to build and operate the business.
- No Sharing of Control: Issuing preferred stock shares typically grants investors some significant control rights, including a board seat and veto rights concerning specific corporate actions, whereas these control rights are rarely granted to investors under convertible notes. A survey by Fenwick & West LLP revealed that compared with preferred stockholders receiving a board seat in 70% of seed financings, convertible noteholders were granted a Board seat in only 4% of such financings.
- Dilution of Equity: By issuing convertible notes, companies permanently give some of their equity away. In this case, it’s more difficult to estimate the cost of equity than that of debt. The lack of a valuation makes it challenging for a startup to estimate the actual cost of convertible notes.
Convertible Notes vs. Equity Considerations for Investors
- No Need for Valuation: Investors generally favor getting the debt converted into security at a heavily discounted price with the hope that a company is on its way to being very successful. The main advantage of using convertible notes is that they don’t have to valuate the company until the Series A round of financing — when there’s more data to base the company’s valuation. Valuations are challenging in a company’s early stages because there aren’t enough data to reasonably determine a startup’s worth. By putting them on a short path to a priced round, convertible notes provide value to the investors.
- Risky Investment: An investor may face issues if the company can’t raise subsequent financing. Many convertible notes don’t include provisions for an automatic conversion on maturity. Most startups end up consuming vast amounts of cash in their early stages and may not have the funds to repay the note at maturity if it doesn’t convert.
- Lack of Enough Control: Some stock investors get additional economic benefits, like pro-rata rights and a liquidation preference. However, as per the Fenwick Survey, only 9% of the preferred stock seed financings included a participating preferred liquidation preference.
A startup in its nascent stages may not be able to decide which financing structure is most suited to its needs when trying to raise new capital to finance its growth. Using convertible notes or issuing shares is one of the companies’ significant decisions when raising investment funds.
Though convertible notes can help a startup get its operations up and running, equity doesn’t have to be repaid as debt does.
No matter which route is taken, companies will have to undergo a valuation at some point in time. Getting portfolio management software from Diligent Equity can help you streamline the complex process of managing cap tables.