Most start-ups initially fuel the idea behind the business with capital raised from friends and family. This “seed round” financing is often only enough to prove the concept of the business, but perhaps not enough cash to support full development the business plan. Start-ups are then left with prospect of raising additional capital from other sources before the business revenues exist to support the cash flow needs of operations.
This second round of financing often takes a different shape than a sale of common equity. Angel investors or venture capital partners usually request some kind of preferred return, that often comes in the form of a convertible note. A convertible note has three features that serve to benefit and protect the investor.
First, the convertible note incorporates an increased interest rate of typically between 8-12 percent. The interest payable under the note can accrue until the maturity date, with the term of the note usually maturing in 18-24 months. At maturity, the note can either be converted to equity or paid in full. The company is betting that it might be able to raise additional capital before the note term concludes. The investor is betting that it will have returned an above-market return on its investment or, alternatively, its investment in the company will be worth substantially more than it would be at the time of the investment when converted. How, then, does the investor protect the upside?
The allocation of this risk is illustrated in a second feature of the convertible note: the conversion discount. You will see the conversion discount detailed in two ways: (i) a percentage discount on the valuation or (ii) a valuation cap that fixes the valuation of the company for the purposes of conversion. The percentage discount can range between 10-25%. The valuation cap, on the other hand, can present significant value for in the investor if the company achieves its projected growth. In practice, the valuation cap serves as a ceiling for the company’s value when determining the conversion rate of the note amount regardless of whether the fair market value exceeds the cap at the date of conversion.
Third, the holder of the convertible note will be paid a significant premium on the amount of principal and interest outstanding in the event of a sale of the company. Recently, we have seen the premium range from 1.5x to 2.5x the amount of principal and interest due at the time of the change in control.
Start-ups interested in utilizing the convertible note need to think carefully about impact to the company’s capitalization table upon conversion and the rights granted to the holder of the convertible note. Tune in next month for more on that topic.