Looks like a duck, quacks like a duck, but tastes like chicken.
Despite the fact that the financial terms of debt don’t work for startup investors, the most common form of seed funding for startups looks like debt and legally is debt but doesn’t act like debt. Specifically, this investment form is called “convertible debt” or, more commonly, a “convertible note.”
In a convertible note, the investor is legally lending money to the company for a specific length of time and a specified, fixed interested rate. However, unlike a bank loan or any other traditional debt, the interest payments are not paid monthly or quarterly. In fact, the debt is typically never repaid as cash but is, instead, usually converted to shares of the company. That is, it is intended to be repaid as “equity” in the next round of funding.
In the use of a convertible note, the assumption by both company and investor is that in the near future, the company will be selling equity to investors. Typically that sale is expected within six to twelve months. Often, that first round of equity marks the transition to the startup-phase capital (a.k.a. “Series A,” shorthand for “Series A Preferred Shares”). See the chart in Chapter 3 for a reminder of the funding phases.
In that equity round, the convertible note “converts” to equity, using a formula specified in the note. Typically this includes a discount to the listed price per share, specified as a percentage. The total amount of money used to calculate the number of shares is the sum of the principal and interest on the debt.
For example, a company might have raised $200,000 using a convertible note with a fifteen percent discount and five percent annual interest rate. A year later, that company could be raising $1,000,000 at $1/share. The investors who bought the note convert their investment into shares at $0.85/share (a fifteen percent discount from $1/share) and receive $210,000 worth of shares (the original $200,000 plus five percent interest). Those investors buy a total of 247,058 shares ($210,000 @ $0.85/share = 247,058 shares). Those shares are identical in terms to those purchased by investors for $1/share.
There are two advantages to using convertible debt. First, the amount of legal paperwork required to “close” the investment is far less than equity and thus far less expensive. Second, the value of the company does not need to be negotiated up front, so that discussion can be postponed until the larger round of funding is sought as equity.
Determining the value of a seed-stage company is difficult. Rather than tackle that challenge, it is far simpler to negotiate an amount for the added risk in investing early, and this value is specified as the discount and interest rate in the convertible note. In general, for investing, the higher the risk, the greater the reward must be and the discount provided to that added reward.
Discounts vary between ten and fifty percent, with most commonly seen between fifteen and twenty-five percent. Interest rates are typically between five and ten percent, annualized. All these values vary as the market changes for early-stage investments.
Lastly, do note that in the case of failure, convertible debt has one advantage to investors over equity. If no funding is raised by the date listed on the convertible note, then the lenders may “call” the debt and seize control of the company. “Calling” the loan is a typical right of lenders when the loan is not paid back on time.
Convertible notes always specify an expiration date (typically six, nine, or twelve months, but sometimes as long as twenty-four months). Convertible notes do not typically include any payments during that time period. Instead, the interest accumulates as part of the eventual conversion. However, upon expiration of the note, the principal and interest are legally due to the lenders. If those payments are not made, then any one lender can force the company into bankruptcy and force the sale of any assets to repay the loan.
More typically, if a startup fails to raise the promised equity round and if that company has some other way to continue to stay in business, the convertible note holders will agree to convert their shares to equity at some agreed-upon value.
If the startup has failed to raise the promised equity, then it usually has also failed to meet the milestones it promised the convertible note investors and thus, likely, has run out of money. So, by the time the note expires, there usually is no money to repay the investors, and ninety nine times out of hundred, the investors simply write off their investment as a total loss and move on.
However, you may find yourself in that one-in-one-hundred position where an investor believes your company has some value and, instead of quietly writing off the investment, seizes the whole company away from you.