Other people are excited about your idea. Great news! Naturally, they aren’t gifting the company their hard-earned, but that’s ok because they will spot you a loan. So, what’s in it for them? Well, their debt may convert to equity and they’ll get to own a piece of your dream.
How does it work?
Put on your thinking cap. Just say...
- An investor invests $100,000 in your start-up as a convertible note.
- The terms of the note are that the debt will convert to equity at a 10% discount and conversion will be automatic after a qualified financing event at $1,000,000.
- If a further round of funding occurs at $2,000,000, the investor’s note will automatically convert to equity and the investor will be issued with a parcel of shares.
- Importantly, as the note provided the investor with a 10% discount, the investor will be issued more shares as a result of the $100,000 debt conversion than would otherwise be associated with a $100,000 investment under this subsequent funding round.
Are you lost yet?
Let’s say the shares under the subsequent funding round are priced at $1.00, the noteholder, by virtue of their 10% discount, will only have to pay a price of 90 cents per share. The advantage of this is that the noteholder will receive 111,111 shares for the price of 100,000 shares.
Take a deep breath
And don’t forget the conversion cap…
Often, in addition to, or in place of a share price discount, a convertible note may include a conversion cap. A conversion cap acts as a maximum valuation (and price per share) upon which the debt will convert.
In the example used above, if the cap was set at a valuation of $3,000,000, and there was no set share price discount, the note would generally convert at the same price per share paid by the new investors. However, if a further funding round values the business above $3M, the noteholder will receive a discounted share price and accordingly be issued more shares for each $1 invested when compared to the subsequent equity investors. This is because the maximum price per share that the noteholder will convert at is limited by the cap.
If you survived that then let’s talk about equity. Relax, grab a cup of tea, put your feet up and take your thinking cap off. We promise this will be a lot easier.
With an equity offer, your start-up will be assigned a pre-money valuation and a share price will be agreed. Cuts out the guesswork for the investor - they know exactly what terms and how many shares they will receive.
Whoo-hoo! Look how short this example is
- The start-up has a pre-money valuation of $1,000,000 with 1,000,000 shares in issue. This puts the share price at $1.00 per share.
- An investor invests $100,000 and receives 100,000 shares.
- The post money valuation is $1,100,000.
So if convertible notes are more complicated, why are they still a popular choice?
- Valuing your business: for many early-stage start-ups, it can be difficult to determine the value or appropriate price per share. Convertible notes allow the company and investor to defer the valuation negotiations until a later round of financing.
- Low expense: convertible note funding rounds are generally faster, simpler and cheaper than equity rounds. This is because there’s no need to negotiate share price or issue shares at the time of investment.
- Control: As no shares are issued at the time of investment, the founders of the company can retain their voting rights in the company. Therefore, the ability to make decisions for the future of the company is not usually impacted unless the note converts to equity.
Sure, it’s easier to understand but what are the other advantages to using equity?
- Commitment: the funding received from investors is committed to your business and the success of your business. Investors will only realise their investment if the business is doing well. Additionally, outside investors can bring valuable skills, contacts and experience to your business.
- No repayments: as there are no costs associated with servicing bank loans or debt financing, it allows you to use the capital for business activities. Therefore, not having the burden of debt can be a huge advantage, especially in a start-up business.
It doesn’t matter how great your start-up is, cash is the lifeblood of business. Run out of it and it’s game over. Take the guesswork out of capital raising and get the advice of a BlueRock professional. We understand that it’s your baby, and we want you to succeed.