When sourcing capital for a new business venture, entrepreneurs utilize one of two basic structures: debt or equity. Debt is a capital source with a finite life and clearly defined return profile known at the initial investment. With debt financing, a company is required to pay interest throughout the term of the loan with principal repaid at maturity. Conversely, equity investors are issued shares representing ownership in an enterprise. While equity does not require repayment over a defined time period, an entrepreneur’s stake in his or her company is diluted through the issuance of equity to outside investors.
Given the dynamics of early-stage companies, venture capital investors use a hybrid funding mechanism, convertible debt. Convertible debt, in the context of a venture capital financing, is a funding structure that combines the benefits of debt and equity into a single capital source. Convertible debt, usually in the form of a convertible note, is essentially a loan which converts into equity at a later date.
A convertible note is a short-term loan with maturities ranging from 12 to 36 months. Instead of paying interest in the form of cash, which would deplete valuable resources of a young company, interest accrues until maturity or conversion. A conversion of the loan (plus accrued interest) into equity is triggered by a subsequent priced equity financing round, typically known as a Series A financing. To compensate convertible note holders for the additional risk assumed with investing at an early stage, most convertible notes feature a conversion price below that of the subsequent financing round through the use of a valuation cap or a discount on the purchase price. Importantly, a valuation cap and a discount are mutually exclusive conversion features thus cannot be applied simultaneously. The note holder will ultimately utilize the conversion feature resulting in the most advantageous purchase price. Below is a demonstration of how a convertible note functions in practice.
Convertible Note Mechanics
After conducting due diligence, an angel investor makes a $200,000 investment in NewCo, a promising young startup raising seed capital. NewCo issues the angel investor a $200,000 convertible note with a two-year maturity accruing interest at 5%.
The terms of the note dictate a mandatory conversion upon a subsequent Qualified Financing, defined as a financing in which NewCo raises $1 million or more. Additionally, the note includes a conversion feature that dictates a conversion price at a 20% discount to the offering price of the Qualified Financing.
NewCo has experienced early user adoption and finalized its marketing strategy. In an effort to expand, NewCo is seeking $1 million in funding at a pre-money valuation of $2 million, or $1 per share, approximately one year after issuing the convertible note. The angel investor’s note, with accrued interest, is now worth $210,000, converts into equity at a price per share of $0.80. NewCo issues the angel investor 262,500 shares.
The angel investor now has equity in the company worth $262,500 from an initial investment of $200,000, resulting in a 31.25% return.
Suppose the angel investor’s note also included a pre-money valuation cap of $1.5 million in addition to a 20% discount. Upon the Qualified Financing, the note would convert at the lesser of the 20% discount or a valuation cap of $1.5 million. At an aggregate valuation of $2 million or $1 per share, applying the discount results in a $0.80 per share purchase price. However, with a valuation cap of $1.5 million, the note would convert at $0.75 per share ($1.5 million cap divided by $2 million pre-money valuation times the price per share of $1). The resulting conversion would equate to 280,000 shares, or a 40% return to the note holder.
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If you would like to learn more about Convertible Debt, read our related blog post or download our Convertible Note Whitepaper.