Do Convertible Notes Increase The Post-money Value Of The Round They Convert Into

Executive Summary

Convertible Notes Have Get a Very Popular Fundraising Instrument

Between 2022 and 2022, the volume of rounds including debt instruments has grown c.4x.
Particularly for seed rounds, convertible notes accept go the preferred fundraising instruments for many startups.
But convertible notes have certain implications which tin can sometimes prove detrimental to startups.

Convertible Notes Are a Hybrid of Debt and Equity

Convertible notes are originally structured every bit debt investments, just have a provision that allows the principal plus accrued interest to convert into an disinterestedness investment at a later date.
This allows the original investment to get done more quickly with lower legal fees for the visitor at the time, merely ultimately gives the investors the economic exposure of an equity investment.
Typical terms of convertible notes are: interest rate, maturity date, conversion provisions, a conversion discount, and a valuation cap.

The Pros of Convertible Notes

Convertible note financings are simpler to document from a legal perspective, meaning that they are less expensive and quicker to execute.
Convertible notes avoid placing a valuation on the startup, which can be useful particularly for seed stage companies which have not had enough operating history to properly set a valuation.
Convertible notes are proficient bridge-upper-case letter or intra-round financing options.

The Cons of Convertible Notes

If time to come equity rounds are non completed, the convertible note will remain debt and thus require redemption, potentially pushing however-delicate companies into bankruptcy.
To avert the above, terms and conditions can exist fix that, if taken likewise far, defeat the purpose of the convertible annotation and end up taking as much time and effort as a traditional equity round.
Sure clauses such equally the valuation cap and the conversion discount can complicate future equity raises by anchoring price expectations.

The vast majority of high-growth startup companies rely on some form of outside financings such equally funding from angel funds, traditional venture capital, loftier internet worth investors, or friends and family unit. While identifying a viable market and making a great pitch are crucial to raising investment funding, there is a seemingly endless assortment of other considerations that demand to exist addressed earlier those funds show up in your bank account and you are off and running to create the next big matter. In this article, I am going to expect at one of those major decisions that most entrepreneurs and companies must face when they are raising investment funds and that is the pros and cons of using convertible notes to finance your company.

Convertible notes have become increasingly popular in the globe of startup financing, particularly in seed stage companies. However, before going down this path, it is important to understand the potential pitfalls of this blazon of financing and whether or not information technology is the best choice for your company. I will starting time give a brief overview of the bones concept of a convertible notation and how it has some attributes of both debt and equity, and then I will look at the pros and cons of this grade of financing.

US VC-backed companies raising rounds that include debt

The Basics

While everyone knows that an investor gives coin to a company with the goal of getting more back in the end, at that place are many different means this takes shape in practise.

Equity Investments

When most people retrieve of an investment, they are thinking about equity. In an equity investment, a visitor sells a percent of their company (disinterestedness) for a sum of coin. When a company raises funding by selling equity, in that location is no fix schedule for the investor to get repaid, and the investor generally counts on making their money dorsum, plus a render, in a futurity liquidity event (such every bit an acquisition of IPO) or through distributions of future profits. In a typical venture majuscule investment, an acquisition or IPO is almost always the way that investors brand their money, with distributions of cash flow being a rarity. Another key point about equity investments is that because the investor is a part possessor of the visitor, they typically have some sort of voting rights that govern various decisions of the company.

Most equity investments in venture capital-backed companies are structured equally preferred stock, which is different than simply $X for Y% of the visitor. When the investment is structured as preferred stock, this typically comes with terms such as a liquidation preference, a preferred dividend, and approval rights over certain company decisions. In about types of preferred stock, the liquidation preference ways that in a liquidity event, the investors get the value of their investment dorsum, plus whatsoever preferred dividends, prior to the remainder of the funds being distributed amongst the % ownership. The preferred dividends are generally not paid in cash, but accrued and paid out when there is a liquidity event. As common stock is generally endemic by founders and employees of the company, this means that all the investors must be paid dorsum plus a guaranteed return (the preferred dividends) prior to whatever funds being distributed to the common stock. In addition to regular voting rights, the preferred stockholders as well frequently have additional approval rights over items such as the terms of subsequent rounds of financing and acquisition opportunities.

Common vs. Preferred Stock

	Common Stock	Preferred Stock
Ownership	Yes	Yes
Voting Rights	Yes	Yes
Veto Rights	No	Typically Yes for decisions such as new funding or M&A
Dividends	Typically No	Yes
Liquidation Preference	No	Aye
Gain on auction of company	Receives share of proceeds on a percentage buying footing, after debt is satisfied and preferred stock receives its return of capital plus dividends.	After debt is satisfied, receives return of capital plus dividends, and shares in remaining proceeds on a percent ownership basis.

Debt Investments

The about typical type of debt is a loan with a set schedule for repayment of primary and interest. Assuming the company can make the payments, the investor knows what return they are getting in accelerate. Given the uncertainty of early-stage startups, debt is non very typical when it comes to funding this type of risky venture. Nonetheless, in that location are some institutional investors that provide debt to after-stage venture-backed companies, especially those with recurring subscription payments such as SaaS companies.

There are a few notable facts when it comes to debt. In contrast to equity owners, debt holders do not have an buying interest in the company and exercise non take voting rights. However, when it comes to the priority of payments in a liquidation scenario, debt holders are paid in full earlier equity holders, and then information technology is perceived equally a less risky investment. When it comes to the complexity of documentation and legal work that goes into setting upwardly various investments, it is simpler and less expensive (at least in reference to a typical startup funding deal) to structure a debt deal in comparison to equity.

Convertible Notes: A Hybrid of Debt and Equity

In short, convertible notes are originally structured as debt investments just accept a provision that allows the principal plus accrued interest to convert into an equity investment at a later date. This allows the original investment to get washed more quickly with lower legal fees for the company at the fourth dimension, but ultimately gives the investors the economic exposure of an equity investment.

Typical Terms and Provisions of Convertible Notes

Interest: While the convertible note is in place, the invested funds earn a rate of interest similar any other debt investment. The involvement in not typically paid in greenbacks, but accrued, which means the value owed to the investor builds upward over fourth dimension.

Maturity Engagement: Convertible notes carry a maturity date, at which the notes are due and payable to the investors if they have non already converted to equity. Some convertible notes have an automatic conversion at maturity.

Conversion Provisions: The primary purpose of a convertible notation is that it will convert into equity at some point in the future. The most mutual method of conversion occurs when a subsequent equity investment exceeds a certain threshold. This is chosen a qualified financing. At this time, the original principal plus any accrued interest converts into shares of whatsoever new disinterestedness was just sold. In add-on to getting the do good of the accrued interest, which buys the convertible note holders more shares than they would take if they had waited and invested the same amount of money in the equity round of financing, they often go several additional perks in substitution for investing before. In the event that a qualified financing does not occur before the maturity date, some convertible notes besides include a provision in which the notes automatically convert to equity, at a gear up valuation, on the maturity appointment.

Conversion Discount: When the convertible notes convert to equity in the effect of a qualified financing, not only practise the note holders go credit for both their original main plus accrued involvement to determine how many shares they receive, they also generally get a discount to the price per share of the new disinterestedness. For instance, if the discount is xx% and the new disinterestedness in the qualified financing is sold at $2.00 per share, the convertible note'southward chief plus accrued involvement converts at a share price of $1.60 per share.

Example: An investor purchases $25,000 of convertible notes that carry an viii% interest rate and a 20% conversion disbelieve. In a qualified financing that occurs 18 months subsequently the convertible notes are sold, the company sells disinterestedness at $three.fifty per share. At this point, the notes will have accrued $3,000 in involvement, making the amount owed to the note investor $28,000. With the 20% disbelieve, the conversion toll for the notes is $2.eighty per share, and the investor receives ten,000 shares of the new stock. Had the investor waited to purchase the stock at the time of the qualified financing, they would have received 7,143 shares of stock, and so information technology is clear there is a large reward to the convertible note investor for taking the risk of investing earlier

Valuation Cap: In add-on to the conversion discount, convertible notes also typically have a valuation cap, which is a hard cap on the conversion cost for noteholders regardless of the price per share on the adjacent round of equity financing. Typically, any automatic conversions that occur at the maturity date (if no qualified financing has occurred) are at some price per share that is lower than the valuation cap.

Equity vs. Debt vs. Convertible Notes

	Disinterestedness	Debt	Convertible Debt
Buying	Yeah	No	No while convertible debt is outstanding, so Yes after information technology converts to equity.
Voting Rights	Yes	No	No while convertible debt is outstanding, and then Yeah afterward it converts to disinterestedness.
Repayment of Majuscule	No repayment until sale of company.	Repayment on fixed schedule.	Repayment on maturity, or converted to equity and no repayment until sale of company.
Payment of Dividends or Involvement	Dividends accrued, and paid out upon sale of company.	Interest paid on fixed schedule.	Interest accrued, and either repaid on maturity or converted to disinterestedness.
Payment on Sale of Company	Paid after debt satisfied in full, and receives render of capital and accrued dividends (if preferred equity) plus share of remaining proceeds. Unlimited upside.	Paid prior to equity, and receives remaining capital plus whatsoever unpaid involvement. Upside limited to invested capital plus interest.	If visitor is sold while convertible debt is outstanding, upside is typically capped at 1-2 times invested capital. If company is sold after it is converted to disinterestedness, it is paid after debt is satisfied but receives return of majuscule and accrued dividends plus share of remaining proceeds, and upside is unlimited.

Pros and Cons of Convertible Notes equally a Funding Mechanism

Now that we have discussed the typical terms and construction of a convertible note, we will now take a look at some of the reasons why companies apply them as a way of raising investment funds, and some of the drawbacks besides.

Pros

Convertible notation financings are simpler to document from a legal perspective. This means that they are generally less expensive from a legal perspective and that the rounds can be closed more chop-chop. The reasons for this are pretty unproblematic, being that the company and the investors are putting off some of the trickier details to a later date. In most disinterestedness financings, numerous corporate documents need to exist updated to close the circular such equally certificates of incorporation, operating agreements, shareholder agreements, voting agreements, and various other items. All of this adds to the time and expense of completing a round of equity funding.
Raising a convertible note as opposed to equity allows the company to delay placing a value on itself. This is particularly attractive to seed-stage companies that accept not had time to bear witness much traction in terms of their product and/or revenue. In commutation for giving investors a discount on the price that is fix later, the visitor is able to push that decision to a afterwards date. Because of this, convertible notes are oftentimes used as the first outside funding invested in many companies, and a large number of institutional seed investors such as 500 Startups exclusively utilise convertible notes in their accelerator investments.
For a variety of reasons, many companies demand to raise some corporeality of funding between larger rounds of equity, and the features of a convertible note make information technology an platonic vehicle to consummate those types of transactions. For example, i company that I have worked with had a transformational software deal with a large enterprise customer that was gear up to close. The company would need to ramp upwardly its staff in order to service the new client, and was planning to raise a new circular of equity one time the bargain was signed; yet, they could non disclose the specifics of the deal until that fourth dimension. In order to get a jump offset on the work once the deal closed, the visitor wanted to raise a smaller corporeality of funds via a convertible note as information technology would allow the funding to close more quickly. Information technology would too let the company to delay the valuation determination for the equity round, as that would likely be more favorable once they were able to disclose the total details of the new contract.

Cons

While there are many reasons why companies and/or investors choose to utilize convertible notes, both sides of the deal really need to think through the potential future implications of using this method of financing. The biggest issue that I accept seen with seed stage companies is the question of what happens if the company cannot, or chooses not, to raise subsequent equity financing. While many convertible notes practise include provisions for an automatic conversion on maturity, many do not. Given that nosotros are mostly discussing very early on stage companies, about of these companies are burning greenbacks, and will not have the funds to repay the note at maturity if information technology does not convert. The best way to avoid this situation is for both the company and investors to have a articulate plan for both success and failure. In well-nigh cases, if a company cannot raise additional funding past an initial convertible note seed investment, it is because the company does non have traction and volition either cease upwardly going out of business organization or existence acquired for a nominal amount. One interesting example from my work involves a company that received a seed investment in the form of a convertible notation from a startup accelerator, and was not able to enhance additional equity funding, merely was able to gain enough traction to continue operations and get to cash flow breakeven. The visitor did not have nearly enough cash to repay the annotation, merely information technology was not going out of business concern either. However, if the investor foreclosed on the company, information technology would have essentially put the visitor out of business organisation and guaranteed that their investment would be worth nothing. This left both the company and the investor in an awkward position that took several years to go resolved.
The awkward situation of the visitor described in the preceding anecdote tin be avoided by negotiating the terms of an automatic conversion at the maturity of the note. However, if y'all get too far down the route of defining what that next round looks similar in regards to all of the terms and provisions that would be included in a typical equity round you lot actually lose some of the benefits of using a convertible note in the get-go identify. One example related to a company that I take worked with involving a promising software startup that was graduating from an accelerator program. Information technology had a basic production, some name brand clients had already signed contracts, and the visitor had attracted potential investors. They chose to fund the circular with a convertible note, but given that the note may take been enough funding to take the visitor past the maturity date, they wanted to know what their investment would exist like if that happened. Every bit it turned out, this led down the road to negotiating exactly what the specific terms of that equity round would look like, and the company concluded upward spending as much on legal fees equally if they had just done the equity round to begin with.
The bulk of convertible notes issued in seed funding scenarios at this point in fourth dimension include a valuation cap and an automatic conversion price. While yous are technically delaying putting a cost on the visitor, ofttimes the cap and conversion cost finer acts to ballast the price negotiations of the next round. Even if investors are willing to pay for a large uptick in valuation from the note valuation cap, you tin can end up with some very strange situations. For example, if the subsequent round of equity is preferred stock with a liquidation preference equal to the price per share of that circular, convertible note holders tin stop up with a liquidation preference of several times their investment if there is a large uptick in valuation. In situations similar this, the new investors may try to force the note holders to adversely meliorate their terms in lodge to close the deal.

EXAMPLE: A startup visitor with 1,000,000 shares of common stock closes a seed funding round of $1,000,000 in the form of a convertible notation, with a valuation cap of $five,000,000 pre-money valuation on the next circular of financing. For simplicity, presume the note carries a 0% interest rate. The company makes a lot of progress and has a venture capital business firm willing to do a $iv,000,000 Series A financing at a pre-coin valuation of $20,000,000, with a liquidation preference of 1x. The $4,000,000 series A investment will buy 200,000 shares of preferred stock at $20/each, with each share carrying a liquidation preference of $xx, plus any accrued dividends. Considering of the valuation cap, the $1,000,000 convertible annotation will convert to the same type of equity at the rate of $v/share, but those shares will have a liquidation preference of $20/each plus dividends which means they would effectively take a 4x liquidation preference! It is highly unlikely the serial A investors would allow this to happen, and would probable crave the convertible note holders to renegotiate.

Parting Thoughts

When information technology comes to using convertible notes equally a seed investment, the all-time advice I tin give is to understand all the implications of the various potential outcomes. Make certain you know what happens if yous exercise not end up raising additional equity, and besides what happens if things go spectacularly well and y'all are able to raise additional disinterestedness far above the valuation cap (if that is part of the annotation).

Several investors and manufacture organizations accept tried to put together template term sheets for both convertible notes and equity rounds. Y Combinator, a well-known startup accelerator program that has provided seed financing to hundreds of startups, adult the Condom (Simple Understanding for Future Equity) with the goal of creating a standard seed investment template that addresses some of the problems that they have seen with convertible notes. Y'all can find a link to the SAFE documents here: https://www.ycombinator.com/documents/#safe

500 Startups, some other prominent Silicon Valley seed investor, has also produced a set of standardized documents for both seed equity and convertible debt chosen Buss (Proceed It Elementary Security). This effort is very similar to the Condom set of documents, but in their stance, they think this is an improvement on Y Combinator's earlier endeavour. I retrieve information technology's helpful to have a expect at multiple options, and in the stop what is most important is that the startup and the investors agree that the terms are fair. You can find a link to the KISS documents here: 500 Startups

The examples to a higher place are helpful places to start in regards to looking at documents that take been used successfully many times over, simply I would caution that every situation is unique. I would definitely non recommend closing a round of investment without a lawyer that is knowledgeable in fundraising for startups, and I often recommend that startups work with a fundraising skillful who can help them understand how to approach their fundraising necessities in the most efficient and fruitful way.