You might be considering taking on debt to finance your company, but before signing the deal and popping the champagne, you’ll want to think about how this financial instrument will affect your company later down the line. This article will provide a refresher on the terms negotiated during a convertible debt agreement and examine the impact on ownership for the note purchaser (and founders!) during a follow-on fundraise.
What Is The Difference Between Debt Fundraising And Equity Fundraising?
Some companies opt to take a loan to pay for their starting costs, which must then be repaid to the investor after a certain trigger or on a certain agreed-upon date. Other companies prefer to enter into an arrangement where the investor pays upfront in exchange for a certain percentage of ownership of the company; this will also establish a baseline company valuation.
These financing decisions play out in different ways, so choosing between debt and equity financing should not be taken lightly. In this post, we’ll focus on a hybrid of debt and equity, commonly referred to as convertible debt.
Convertible debt, also referred to as a Promissory or Bridge Note, is a loan made out to the company with a provision stating that the principal (or original amount invested) plus interest will eventually convert from debt to equity.
Convertible debt allows you to raise money for your company today, and avoid determining your company’s valuation until a later date in the future. To do so, convertible debt relies on interest rates, conversion discounts, and valuation caps, which impact your next round and the subsequent dilution of your founders.
Fundraising Glossary: Convertible Debt
If you have decided to take on convertible debt, there is some vocabulary you should feel comfortable with before venturing out into the world of potential investors singing your company’s praises.
The principal is the original amount invested and specified in the convertible note (which is the “IOU” document issued by the company to the investor).
The principal will usually be associated with an interest rate at which interest will accrue while the debt is outstanding. The accrued interest is normally paid back in shares. This means that, up until the maturity date of the convertible note, interest will accrue. At the maturity date, all of the shares that have built up (due to interest) are paid to the investor.
The maturity date is the date at which a note’s principal and interest are due to be repaid to the investor, but such repayment is not likely to ever occur because the goal is that the investment converts into shares. Some convertible notes have an automatic conversion clause, wherein upon the maturity date laid out in the original agreement the notes convert into equity.
The conversion discount is a provision negotiated by investors that sets how far below the price per share (set in the equity financing) the convertible note will convert into stock.
Companies usually grant investors a conversion discount because those investors believed in you before anyone else. So, if your next round has a $3 price per share and your investor’s conversion discount was 20%, your convertible shareholders’ original investment (the principal) plus any interest accrued will convert into the new round of shares at price per share of $2.40 (since $0.60 is 20% of $3).
Convertible debt also often has a valuation cap. A valuation cap is an optional provision in a convertible note that allows for an investor to “cap” the dilution of their investment, by establishing a maximum valuation that will apply to their conversion in the next financing round.
So if your next fundraise sets a valuation for your company above the one outlined in the valuation cap, your investor’s note will convert according to the capped amount (and your investor will receive more equity than if the actual higher valuation set forth in the fundraise was used).
Convertible Note Implications
If your company decides to take on debt financing, the aforementioned terms will play a critical role in determining founder dilution. Consider two example scenarios:
Let’s assume that Ivan, the investor, contributed $300,000 in the form of a bridge note to your company’s last fundraise (principal amount), and the note had a valuation cap of $3,000,000. Now, you are raising a Series A round which is setting your company’s worth at $10,000,000 pre-money. In this new round, each share is priced at $1.
It’s the crescendo moment that Ivan’s been waiting for—his investment conversion! To calculate the impact of the valuation cap on the conversion of Ivan’s investment, we will want to divide the cap ($3,000,000) by the next round valuation ($10,000,000) which gives us a $0.3 price per share.
To find out how many shares will convert into Series A shares from Ivan’s original investment, we will want to take $300,000 and divide it by the price per share determined by the cap ($0.3), which yields 1,000,000 shares.
This is roughly 700,000 more shares than what the Series A investors would receive for the same investment, which is equivalent to a 3.3x return on investment (1,000,000 shares / $300,000, not including interest).
Clearly, a valuation cap that is lower than the actual valuation of the company (set forth in their future round) is more favorable for the existing investors that are converting debt into equity.
In the second scenario, we will model an investment round with a discount rate and a valuation cap that is higher than $10,000,000. In most cases, there will be both a valuation cap and a conversion discount applied to a bridge note, and the one that is more favorable to the investor, i.e., converts into more shares, will apply.
Using the same premise as the previous example, consider a situation where the cap was over $10,000,000 (so it wouldn’t be more favorable in this financing) and the conversion discount was 20%.
In this case, Ivan would receive 375,000 shares ($300,000 / $0.8) upon conversion.
In sum, if your company has a significantly higher-than-expected valuation during the equity financing, Ivan the investor’s percentage ownership could be pretty small at conversion (even with a discount). This risk makes valuation caps, like discount rates, important for keeping these instruments attractive to early investors.
Striking The Right Cord: Modeling Your Next Financing Round
If your company has financed itself with several convertible notes, modeling your next round and determining dilution can be a pain. Luckily, Shoobx makes these calculations easy by allowing you to specify the specific terms for each of your investors and providing you with the calculations at the push of a button!