For the past 10 years or so, founders of early-stage startups have been increasingly turning to convertible notes and convertible equity instruments to structure investment rounds, particularly for their first capital raise. Although some angel investors argue that founders should do fewer convertible notes rounds and make more equity deals, it is important to remember why convertible notes have been so popular in the early-stage financing industry. What are the main benefits to founders and investors of a convertible note offering instead of a stock offer? We will be discussing the important terms for your convertible note offering in future posts. But let’s first look at the main benefits of the convertible structure to help you decide if it’s right for you.
You might think, “What’s wrong selling 10% of my company to an investment in exchange for $100,000 to help us get off the ground?”. This is the first problem that convertible notes are designed to solve. It’s the valuation. Let’s say your company is still in beta with its product or looking for a first enterprise customer. Is it logical to place a $1,000,000 post money valuation on the company in this stage? But what if the $100,000 gets you traction and you raise a Series B round at $10 million valuations two years later? You’ll be thrilled to meet your first investor, but you will also feel serious seller’s guilt for giving up such a large portion of your company to an investor who now realizes that it was a very low valuation.
Convertible notes have the advantage that investors and founders can postpone discussing valuation for another day. Based on the company’s valuation, convertible notes can be converted into equity. In our example, instead of receiving 10% of the company for the $100,000, the investor would convert to the round that valued it at $10 million, at a discount of, for instance, 20%. The founder saw the value in the $100,000 being used to get the necessary traction and justify a higher valuation. It also avoided the dilution of selling equity at a 1 million valuation. The convertible note investor is happy because he was compensated for taking on extra risk by coming in early and receiving a discount in the new round. The stock is available for purchase at $.80/share, while other investors will pay $1.00/share.
The simplicity second reason is used to justify convertible note. What terms will the initial $100,000 investment be made by the founders to sell their 10% equity stake in the company? What is the difference between preferred shares and common shares? Will the proceeds of a sale go first to the investor or to the founders? What happens if the company raises capital at better terms? What happens if the investor gets those better terms? Or has the opportunity to take part in the new offering to avoid being diluted?
The convertible note can be used to replace company stock. This allows both the founders and investor to put off these decisions until the next equity financing round. Convertible note investors will receive the same rights as the equity financing investor, except that they will convert to the class of shares being offered. Convertible note offerings are generally less expensive than equity financing rounds due to their simplicity. It is important to note that both types offer the issuance and transfer of securities. You will need to consult an attorney to ensure compliance with both federal and state securities laws. The angel financing community has evolved to the point that there are agreed terms for first-money equity offering and convertible note offerings. This reduces negotiation complexity. Convertible note offerings may be simpler to set up, but outside factors such as who your investors and their negotiating leverage will impact the project’s complexity.
Convertible notes are a great addition to the early stage financing landscape. They allow founders to raise capital efficiently without having to grant the rights that preferred stock investors have. Convertible notes can delay discussions about company valuations and preferred stockholder rights but these decisions have to be made. Convertible notes can be viewed as a bridge that will help the company get in the best position possible for a larger round equity financing.