Raising capital is one of the entrepreneur’s most difficult and time-consuming activities. Not all money is the same and the structure of those early investment rounds could have an impact on future returns. Today, seed stage rounds provided by angels or early stage VCs usually come in the form of priced rounds or convertible note/convertible debt. These two vastly different types of securities are used for smaller rounds of financing at the early stage of a company’s life cycle.
Convertible debt is evidenced by short term notes, and is commonly used for financing rounds for early stage companies before or between priced equity rounds. The notes convert to equity when the startup completes its next funding round, typically within 12 to 24 months. A crucial distinction between convertible debt and priced equity rounds is that convertible debt allows the company to defer valuation until that next funding round. Convertible notes can include a variety of innovative terms, but all include an interest rate (often 4%-8% annually) and maturity date. Risk premiums are a key feature of convertible notes, so convertible notes may also include a valuation cap and a discount rate on the share price upon conversion.
Valuation caps protect early investors from dilution in the event that the company is able to leverage early investments into an outsized valuation in its next funding round. Without a valuation cap, early investors may be left with a piece of the pie that is too small to adequately reward the risk they incurred when they invested. Therefore, investors will negotiate a cap on the highest valuation at which the note will convert, regardless of the next round’s actual valuation.
Similarly, the discount rate compensates early investors for early investment risk. Discount rates are commonly 20%, but can range from 0% to 50% depending on the context. If equity is priced at $1 per share during the next round, a discount rate of 20% means that the note will convert at $0.80 per share. A $100,000 note will purchase 125,000 shares – a 25% premium.
Priced equity rounds are the more common investment method. A key difference is, of course, that a priced equity round involves a valuation of the company. Investors commonly seek preferred stock, which may carry a 6% to 8% dividend and a liquidation preference at 1x their investment before the common shareholders participate in the proceeds of a sale of the company. The risk incurred by preferred investors is mitigated by anti-dilution protections and protective provisions, including the right for preferred shareholders to veto certain major actions (e.g., change of control, amendment to governance documents that adversely affect the preferred investors’ securities). Preferred investors may also have representation on a company’s board of directors or managers.
What's Right For Your Business?
Unlike stock transactions, convertible debt deals at their core are nothing more than short promissory notes. Notes are cheap and easy. Convertible debt defers the issue of pricing, involves fewer simpler documents, and allows founders to bring in one investor at a time without a coordinated closing. By comparison, priced equity rounds permanently alter the capitalization of the company by adding new stockholders. Given this permanence and the inherent complexity of these transactions, a great number of different types of deal documents are required for stock transactions.
However, there are two places where the virtues of notes might outweigh their drawbacks: very small initial seed rounds and supplemental bridges between priced rounds. In very early stages when the amount of money is small, founders and investors tend to know each other or at least share affinities for the market, the technology or the customer. In these deals, transaction costs need to be kept really low to avoid becoming a huge percentage of the round. Simplicity tradeoffs make sense because being exact is an unaffordable luxury. In the context of a supplemental bridge, notes can make sense for different reasons: because of the reduced pricing risk. The company has already been priced in an earlier round and milestones and growth are better understood, making it harder for the cap to be wildly off.
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Author: Aimee Haynes
I motivate, I blog, I listen, I give advice, I help, I create, I work with others, I stand my ground when needed, and I am always open to new ideas. In addition to the qualities that define me most, I'm also a Corporate Law attorney working with entrepreneurs, creatives, and small businesses to help them achieve success.