While identifying a viable market and making a great pitch is crucial to raising investment funding, countless other considerations need to be addressed before those funds show up in your bank account. These include angel investors, venture capitalists, high-net-worth investors, friends, and family. While identifying a market and creating a great pitch is crucial for raising investment funds, there are a number of other factors that must be considered before the money appears in your account. This article will examine one of the major decisions faced by most companies and entrepreneurs when raising funds. It is about the pros and cons of using convertible notes as a way to finance your business.
Convertible Notes (also known as “convertible loans notes” or “CLNs”) are becoming increasingly popular, especially in seed-stage companies. Before you decide to go down this road, it’s important to know the potential pitfalls and if this is the right choice for your business. First, I’ll give you a quick overview of a convertible loan and explain how it has both the attributes of debt and equity. Then, I’ll discuss the pros and cons.
The Basics
There are many ways to achieve this goal. Everyone knows that investors give money to companies with the hope of receiving more in return.
Equity Investments
Most people are familiar with equity when they think about investing. A company will sell a certain percentage of its company equity in exchange for money. Investors who invest in equity are not guaranteed to be repaid. They can expect their cash plus a return at a future liquidity event, such as an acquisition or IPO, or by receiving future profits. An acquisition or IPO almost always rewards investors in venture capital investments, and distributions of cash flow are rare. Equity investments are also important because, as a part-owner of the business, the investor has some voting rights to influence the decisions made by the company.
The majority of equity investments made in venture capital-backed firms are structured as preferential stock. This is different from simply paying $X per Y% share. The acquisition will be structured as preferred stocks, which usually include terms like a liquidation priority, a preferential dividend, and approval rights for certain company decisions. The liquidation preference is a feature of most preferred stocks. It means that, in the event of liquidity, investors receive the full value of their investment plus any preferred dividends before the remainder of the funds are distributed to the percentage owners.
In most cases, the preferred dividends do not come in cash but are accrued. They will be paid when there is an event of liquidity. The founders and employees usually own common stock, so all investors must receive their money back along with a guaranteed return. The preferred stockholders often enjoy additional voting rights in addition to their regular voting rights. This includes approval rights for items like the terms of future rounds of financing or acquisition opportunities.
Profits from the sale of a company after debts are satisfied; preferred stock is returned to its capital and dividends plus the share of proceeds received on a percentage basis. After the debt is paid, you will receive your capital back plus tips and a share of the remaining profits based on a percentage basis.
Debt Investments
A loan is the most common type of debt. It has a fixed schedule of repayment for principal and interest. Investors know what they will get in advance if the company is able to make payments. Debt is not a common way to fund startups in their early stages. Some institutional investors provide to venture-backed later-stage companies. This is especially true for companies that have recurring subscriptions, such as SaaS.
When it comes to the debt, there are some notable facts. Debt holders, unlike equity owners, do not own a company or have voting rights. When it comes to priority payments, debt holders will be paid before equity holders in a liquidation situation. This is perceived as less risky because it’s a lower-risk investment. In terms of the amount of paperwork and legal work required to set up different assets, a debt investment is less complicated and more affordable (at least compared to a typical startup funding deal).
Convertible note meaning: A hybrid of debt and equity
What is a convertible loan? A convertible note, which is initially structured as a loan investment, has a provision allowing the principal and accrued interest of that debt to be converted into equity at a future date. The original acquisition can be completed faster and with lower legal costs for the company. However, the investors will still have the same economic exposure as an equity investment.
The typical terms and provisions of a convertible note
Interest The convertible note earns interest just like any other investment. Interest is not usually paid in cash but rather accrued. This means that the value due to the investor increases over time.
Maturity date: The notes of convertible notes have a maturity when they are due and payable by the investors. Some convertible notes convert automatically at maturity.
Conversion provisions: A convertible note’s primary purpose is to convert it into equity in the future. Conversion is most commonly performed when an equity investment in the future exceeds a threshold. This is referred to as qualified funding. The original principal and any interest accrued are converted into shares in the new equity that was sold. The convertible note holders get more shares if they invest earlier, and they also benefit from the interest accrued. Some convertible notes include a clause that if qualified financing is not completed before the maturity date of the message, the messages will automatically convert into equity at a predetermined valuation on the maturity day.
Conversion discount: In the case of qualified finance, the holders of convertible notes receive a discount on the price of each share. If the value is 20 percent and the new equity is sold at $2.00 a share, then the principal plus interest of the convertible notes converts to $1.60 a share.
