Every entrepreneur faces the decision when starting a new company on whether to raise outside capital. If raising capital is the method you choose, you must then decide what type of investing vehicle to use: offer convertible notes or sell equity. Decisions, decisions!
The most common financing methods used by startups with investors includes offering convertible notes (aka convertible debt) or selling equity. This decision on whether to use convertible notes or to sell equity is complicated. Below, I will describe the factors involved in making this decision in the hopes of helping other entrepreneurs better understand when and where to use these two common financing tools.
So what is selling equity? Equity is the ownership by shareholders in a corporation and is usually represented by either shares or percentages. For example, if you own a company that has a value of $1,000,000 and an investor were to invest $500,000, the new value of the company would be $1,500,000 ($1,000,000 + $500,000.) Investors refer to this new value as “post-money” as it is the new value of the company after the investment. Likewise, the $1,000,000 valuation is referred to as the “pre-money.” After the investment process is complete, the original owner of the company would own 66% of the company and the new investor would own 33% of the company based on the contribution each party made to the deal.
What is a convertible note? A convertible note is a loan made to a company at a fixed rate of interest with the right to be either redeemed for cash or converted into shares of the company at a predetermined date or when the company reached specific milestones.
Why would a convertible note be attractive? Offering convertible notes during a seed round of financing for a fresh start-up helps in several ways. One way is that convertible notes avoid the use of the official series letters represented by designations such as Series A, Series B, Series C and so forth. A company can avoid the use of the legal designation Series A for later when the capital requirements are much higher, usually above $1 million. A convertible notes would be more attractive if an entrepreneur were raising less than $1 million and therefore save the Series A designation for later when the company’s cash needs match the amount considered worthy of a Series A designation.
Why do some investors like convertible notes while others don’t? Convertible notes documentation is much easier to create and execute than the documentation required for a Series A round making the investment process fast and less expensive, good things for a new company trying to get established. The documentation for a convertible note is often only 2 to 3 pages with the closing document being no longer than 10 pages. Some investors like the simplicity of convertible notes and the ease of which they are executed.
Yet, let’s think about an investor that brings cash but also brings industry experience and relationships that will help the company succeed. If this investor were to invest using equity instead of debt, the investor would be likely to realize more of a gain. This is because the investor’s experience and relationships help increase the value of the company and only investing through equity can the investor realize their true contribution. Likewise, some investors prefer equity over convertible notes when they expect the company will increase in value faster than the interest offered through a convertible note. If this is the case, the investor would have been better off to have owned equity in the firm as opposed to a convertible note.
A resolution to this problem is to match the interest of convertible notes with the expected increase in the value of the company. This can be done by using an escalating discount rate which essentially increases the return on the note to an investor over time. For example, a deal can be structured that along with the regular interest accumulated on the convertible note, the investor also receives a discount conversion rate of 5% at signing and that rate increases 2.5% each quarter thereafter until the convertible note is cashed out or converted into equity. If the company were to convert the note in 2 years, the investor would have increased their investment by 25% not including the regular interest paid on the convertible note (usually around 7% or 8%). This is essentially the same mathematical affect that would have occurred if the investor had bought equity assuming the company’s value increased by 25%. Some investors find convertible notes attractive because unlike equity the value of a note increases at a predetermined amount, something attractive during the current period where most firms saw their values drop.
Another plus to investors as well as entrepreneurs is that convertible notes can be executed for an LLC while a Series A round of financing requires the company to be registered as a corporation (Delaware C Corporations are the most popular). If the founding entrepreneur and investors have other sources of income outside of the new company, the losses from the start-up can be used to offset those incomes and therefore lower the entrepreneur and investors income taxes.
Why would the company have losses? It is actually common for a startup company that requires an investment to experience losses and an LLC will allow the entrepreneur and investor to capitalize on those losses. However, losses from a corporation must be retained by the corporation and cannot be used to offset other sources of income (corporations can use those losses to offset gains in future years.) There are drawbacks to using LLC’s but to keep this article as brief as possible, we will save that discussion for another day.
Why do entrepreneurs like convertible notes? Entrepreneurs like convertible notes because convertible notes are easy to execute and less expensive than selling equity. The other benefit is that convertible notes allow the entrepreneur to retain their ownership of the company and the entrepreneur is not forced to set a value on the firm. If an entrepreneur were to sell equity, a value of the firm must be established to make it possible for the entrepreneur and investor to calculate the percentage of the firm owned. Often a startup company has very little in assets and therefore it can be difficult to establish a true value for the new firm.
Another positive for entrepreneurs is that convertible notes help avoid over-dilution of the founders by early investors. Entrepreneurs need motivation to work long hours and sacrifice not having a steady paycheck. Ownership by the entrepreneur in the company is the most common form of this motivation for start-up ventures. If the company is worth only $100,000 yet an entreprneur needs $500,000 to launch, the entrepreneur would lose a great deal of ownership if he or she were to sell equity and therefore the entrepreneur runs the risk of losing motivation to see the company succeed over the long-run (something entrepreneurs and investors a like don’t want to experience). By using convertible notes, an entrepreneur can retain ownership of the company and convert those notes into equity later after the company has assets and has increased in value.
Any other positives? Convertible notes also help avoid a nasty down round. A down round is where a company’s valuation is set lower than it had been when it last raised money. This is the equivalent of buying high and selling low. You can see why down rounds aren’t popular with investors and entrepreneurs. By using convertible notes, the company avoids having to sell equity and therefore as mentioned earlier avoids having to legally set a value on the young start-up. Later when the company raises its official Series A round, the valuation can be set without the threat of experiencing a later down round.
As you can see, making the decision to raise capital doesn’t stop with just that decision. An entrepreneur must then decide on` whether to use convertible notes or to sell equity in their firm. The best way to tackle this decision is to discuss both options openly with potential investors and work closely with them to develop the best action for the new firm.
Good luck on your new venture and creating happy investors!
