A successful startup company typically will engage in one or more rounds of seed and venture capital (“VC”) financing. In this post, we discuss the basics of convertible debt financing, which is a commonly used type of financing in seed and early stage deals.
Convertible Debt Financing
Convertible debt is short-term debt issued by a company in the form of a loan that converts into shares of preferred stock if the company receives VC funding. In other words, investors loan money to a startup as its first round of funding. However, rather than the investors simply receiving their money back with interest (as would occur with an ordinary loan), they receive shares of preferred stock as part of the company’s VC financing, usually at a discounted price. The discount is offered to provide incentive for investing in a company at an early stage when the probability of the company succeeding is often at its least certain.
For example, let’s assume that a company raises $500,000 in convertible debt from angel investors and the convertible note provides for a 20% discount in the next round of financing. Then, in the next round (i.e. Series A round), a VC offers to provide $1,000,000 in financing at $1.00 per share of preferred stock. At that time, the company will have raised $1,500,000 in financing ($500,000 from the angel investors and $1,000,000 from the VC). However, while the VC will receive 1,000,000 Series A shares ($1,000,000 in financing at $1 per share), the angel investors will receive 625,000 Series A Shares (500,000 shares at $0.80 per share, which includes the 20% discount).
The Benefits of Convertible Debt Financing
Convertible debt financing generally constitutes a speedier, simpler and less costly transaction than equity financing. In fact, a company can complete a convertible debt round in a short time period generally by issuing a 2-3 page promissory note, which may cost as little as $1,500-$2,000 in legal fees (or a more if a note purchase agreement is also executed, which is customary). Conversely, the issuance of shares of preferred stock is complex and it can take weeks to negotiate all of the terms and documents, which commonly results in considerably larger legal fees.
In an equity financing, a company must be valued to determine the ownership interest in the company that an investor receives from his or her investment. For example, an investment of $200,000 in a company valued at $1,000,000 equates to 20% of the company. However, the same investment of $200,000 in a company valued at $800,000 equates to 25% of the company.
Because the interests of the founders and investors are not aligned in an equity financing (i.e. the lower the valuation, the higher stake the investor receives for his or her investment), a substantial amount of negotiation may be required to close the deal. Also, practically speaking, it often makes sense to delay valuing a company until the Series A round of financing because, at that time, there will be considerably more information about the company and its worth.
Another significant advantage of issuing convertible notes is to avoid giving the investors any control in the company. When investors receive shares of preferred stock, they are typically granted significant control rights, including a board seat and veto rights with respect to certain corporate actions (known as protective provisions). They also have certain rights as minority shareholders under applicable State law (usually Delaware) and receive certain economic rights, such as a liquidation preference. Convertible noteholders are rarely granted any control rights and have no minority stockholder rights.
In a future post, we will discuss setting a cap on the price that an angel investor will pay in the Series A round of financing. The cap is designed to protect investors by limiting the amount they have to pay to convert their debt to preferred stock in the event that the company receives an unexpectedly high valuation in the Series A round. If, for example, the cap is $2 million and the pre-money valuation in the Series A round is $4 million, the amount of the note (plus accrued interest) would convert into shares of preferred stock based on a valuation of $2 million as opposed to $4 million.
While convertible debt is commonly used and has many important advantages, equity financing at the seed stage is also viable. The best course of action depends on your company and business plan.
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