We’ve already written about the difficulties and risks of trying to put a value on your company too early (here), but how does an early stage company raise money without a reliable valuation? One way is through convertible debt.
Convertible debt is pretty much what it sounds like: debt that can convert to equity. A convertible debt financing is similar to a traditional loan in that the company borrows money (often from angel investors, but sometimes from friends and family or even VCs) and commits to repay it with interest by the end of the term of the loan. Unlike a traditional loan, however, the entire principal and accrued interest will convert to equity at the option of the lender or automatically upon the occurrence of certain events. For example, if the company raises a round of venture financing the outstanding principal and interest usually automatically converts into equity of the same type as is being sold to the VCs. By tying conversion to a financing, the debt holders effectively piggy-back on the valuation determined by the equity investors.
A convertible debt financing is often called a “bridge” financing because it provides a company with the capital it needs to continue operations until the next round of venture financing. To compensate the convertible debt investor for the added risk of investing earlier, the conversion to equity is typically at a discount to the price being paid by the VCs (around 20-40% is customary) or the company issues to the convertible debt investor a warrant to purchase additional shares of the equity into which the principal and interest on the loan converts in the financing.
Convertible debt offers several other advantages over an equity financing for a very early stage company, but the most significant is probably that a convertible debt financing is a much simpler transaction and therefore can usually be completed at a much lower cost than an equity financing. If you’re only raising a small amount, the cost savings can be critical.
NOTE: Even though convertible debt starts out as a loan, it is still considered a “security” and therefore all the normal securities laws apply, including restrictions on sales to non-accredited investors, so be sure to consult your lawyer.
Tags: accredited investor, Angel, convertible debt, family, Financing, friends, Seed, VC, venture capital
Tags: accredited investor, Angel, convertible debt, family, Financing, friends, Seed, VC, venture capital
Great article guys. Provided that the note holders don’t plan on being heavily involved (financially) in future rounds, convertible debt is a great way to go.
You mentioned that the discount rate typically range from 20-40%. I’d also point out that the carried interest rates are usually between 6-10% and the term of the note is usually 1-2 years, sometimes with a “step up” in discount rate as the term gets into year 2. These are all “levers” in the negotiation with debt investors – much simpler than equity provisions but still very important!
Good stuff!
Agreed, very timely. Was just at a TCN breakfast on Friends & Family financing and heard an entrepreneur describe how he funded his company in the early days. He wrote a single convertible debt agreement with no discount on conversion. Then, for early investors, he issued warrants for 20% of the investment amount, for those that signed on later he issued 15% warrants, and for the final group before his Series A, he offered 10% warrant coverage (all the terms of the debt stayed the same for all of thee investors)
That seems like it has two practical advantages from the entrepreneur’s perspective. 1) It allowed him to easily reward the early investors for taking the additional risk without each set of investors having a slightly different note agreement. 2) It made it easy for some of his investors to convert the note into cash (to cash out at the Series A) while still having a small investment in the firm (they feel like they still have a small piece of the upside). For many family investors, this what they really wanted. They didn’t want their total investment tied up in illiquid shares waiting for an exit, but did want to “take the ride” at least a little.
Thanks guys, very useful, as always.