Should your business offer its investors debt or equity in exchange for capital? The answer may be both.
There are many ways for a nascent small business to acquire the money it needs to start operations and expand. By now, many owners realize that the traditional bank loan is the most difficult and least advantageous source of capital for many small businesses. They instead turn to venture capital firms or angel investors. When you finally find the right funding partner and shake hands on the amount of capital to invest, the difficult part begins. Should you take the money as debt to be repaid and preserve your equity? Or do you make them true partners by giving them an ownership stake in the company?
In practice, the answer is both because many investments in startup and small businesses today are done by using convertible debt.
Convertible Debt 101
Convertible debt can convert to equity given certain conditions and within certain parameters. It serves as a form of “bridge financing” to give a company access to money immediately while it searches for larger amounts of capital. Convertible debt offers lenders the protections of debt, such as having a claim to the assets in the case of bankruptcy, while also letting them enjoy the potential upside that equity provides if the company succeeds.
Typically, convertible debt is issued in the form of a note with either the lender or borrower having the option to convert it into equity. The note itself lists all of the key details such as the amount being borrowed, the interest rate of the note, the maturity date and provisions for conversion.
The provisions for conversion into equity are absolutely critical for both the lender and the borrower:
Type of equity. Typically, the debt converts into preferred stock instead of common stock. This continues to give the lender (now investor) additional protection in the form of a liquidation preference in case the company goes bankrupt.
Conversion price. One of the features of convertible notes is that it doesn’t necessarily specify the price at which the debt converts into equity. Instead of stating that it will do so at “$10 per share,” it agrees to convert at whatever price the company is able to secure capital at the next significant round of financing. This makes sense for both sides, since agreeing to a fixed price at this early stage would create problems for everyone.
Price caps and discounts. Simply agreeing to convert at a yet-to-be-determined price is typically too risky for lenders. They want extra protections, so the note usually indicates that the conversion price will be capped at a certain amount. It also offers a discount to the valuation as a way to compensate the lender for the additional risk they took by investing early. So the note could state that the conversion price will be the lower of a “25 percent discount from the price of the Series A investment” or “the price per share if the valuation were $X million.” The former is the discount and the latter is the price cap.
In addition to offering additional protections for investors, owners also gain by using convertible notes. Most important, they don’t have to give up equity so early in the life of the company when it may not be worth much. It allows the valuation of any equity to be determined in to the future, giving the owners more time to increase the value of what they have built and therefore letting them give up less ownership in exchange for investor money.
Convertible notes may be a good option for your company. There are many details to consider and if you aren’t careful, a shrewd investor may receive a better deal than you expected or were willing to offer. Talk to your legal and financial advisors to see if convertible notes are a good option for your business.