July 24, 2015 | 6-minute read (1117 words)
If you’re planning a seed round raise, you need to know your way around convertible debt for startups: what it is, how it works, and what the benefits are. While investors in some less well-developed startup hubs are still largely resistant to using convertible notes and some angel investors prefer priced rounds, according to SEEDCHANGE’S Kevin Smith, 93% of early-stage rounds in coastal startup hubs use convertible notes.
So what is a convertible note exactly?
Essentially, a startup convertible note is debt that acts like equity. It functions as legal IOUs but with repayment in shares instead of money. That said, convertible notes must have certain debt features such as interest rates and maturity dates. More on those later.
Key features of convertible notes:
- Short agreements — Note purchase agreements are typically three to five pages, while the note document itself is two pages. Compare that with the 30-40 pages typical for stock agreements. The difference means convertible debt for startups close faster. That means lower legal fees. These work out to around $3,000-$5,000.
- Flexibility — One great thing about using a convertible note for startups is that deals can close at any time.
- No valuation needed — Postponing sensitive negotiations on valuation, is a big advantage for founders. You can address valuation in the future — during your first priced round once you’ve hopefully hit your milestones, and your business will be worth more.
- Standardized terms — Terms have become almost standardized in New York, Silicon Valley, and some other tech hubs. Since that’s the case, you'll find there isn’t a whole lot to negotiate, and deals can close faster.
Key Convertible Note Terms
- Interest rates (are calculated on a simple, not compound basis, with payment made in stock when the notes convert) can be set as a spread over Libor or fixed. For example, rates have been in the 4-5% range lately, but given where the market is today, you might be able to negotiate even lower.
- Maturity date — Convertible debt for startups has a typical timeframe of 12-18 months. We agree with Kevin’s recommendation to go longer, 18 months, if you can. That will give you more time to line up capital.
- At maturity, notes either convert to equity or must be repaid. If you can’t repay the amount owed at that point, investors will usually agree to extend the maturity rather than forcing repayment or liquidation. You’ll need to file a one page amendment to your original agreement to record this.
- Depending on business structure, founders won’t be personally liable for corporate debt — but this is not the case for sole proprietorships or if you’ve commingled business and personal accounts. There are so many reasons why commingling funds is a bad idea, and this is one of the biggest.
If you’re in talks with a potential investor who will only do a priced round and not convertible notes, base your decision to move forward on whether the investor will be a good fit and whether s/he is offering a meaningful investment.
So far, so rosy. But there’s always a catch with convertible debt for startups
Two features of converts that are often criticized and misunderstood are the discount and the cap.
- Discount — The discount is used to compensate early investors for the risk they took in funding your business. A 20% discount on the share purchase price when the debt converts to stock is typical. Think your venture is worth a premium? You could always try to negotiate the rate down, but it will raise questions with investors and send the wrong signals on where you see your business headed and how much of the pie you’re willing to share with early backers.
- Caps can be a point of contention, so let’s be clear on what they are not. A cap is not a valuation of your business. Caps guarantee that your noteholders’ investment will convert to stock at a ratio guaranteed not to fall below whatever the value of the stock is at your Series A round. Basically, they act as dilution-protection for your early investors. Investors can choose to convert at a discount or use the cap, but not both. This aligns investor interests with yours, especially when it comes to raising funds during a later round, and keeps return within a narrow band.
When it comes to terms, try to negotiate a number for the cap that both sides can view as "fair;" $4-$4.5 million is about right for an early-stage company.
If you’d like to see how these conversion scenarios work in practice, fill out this form for a free download conversion scenario template:
How to set yourself up for a successful raise:
Before you start pitching investors, figure out your fundraising game plan, including how much you need to raise. And figure out the minimum you want to accept from each investor. At the seed stage, the total raise is $500,000-$1,000,000. Typically your raise will involve four investors putting in $250,000 each. If check sizes are smaller than this, the administrative hassle increases.
Next, get ready for due diligence. Know and be prepared to discuss how much you want to raise and what you plan to use the funds for within your business. Practicing milestone funding: by identifying discrete goals and setting realistic timeframes to achieve them not only helps your execution, it also sets the stage for large increases in valuation down the road when it’s time to raise more funding.
Although the process of completing your raise might stretch to six months, the timeline with each investor that you do a deal with should be relatively short and straightforward. And you can start putting investor funds to work right away as soon as you close deals with each investor. Don’t forget to update your cap table to include each noteholder you bring on.
For more insight on convertible notes for startups from Kevin Smith and Gadiel Morantes, Chief Strategy Officer for Early Growth, access the presentation deck on slideshare.
Whether it’s your first 409a valuation or your annual update, hiring a qualified professional who can guide you through the process, explain the nuances, and will guarantee its product, is your best bet.
Do you have more questions on valuation or need assistance with startup financing? Ask us in the comments section below or contact Early Growth Financial Services for a free 30-minute financial consultation.