editione1.0.1Updated September 19, 2022
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founder Convertible debt can be beneficial for startups in the following ways:
Immediate access to funds. Unlike a fixed price equity round where there is typically a formal closing date on which a substantial portion of the money comes in, notes can be signed in small amounts ($25K) which individual investors and the company can start using right away. An exception to this is if the convertible note document itself requires a minimum amount of funds to be raised, but this is unusual. If a company is short on cash or needs additional funds to hire engineers or kick off patent work, this quick access to cash as individual investors come on board can be very useful.
Lightweight deal documentation. A convertible note may be only a few pages long, whereas the documentation for a fixed price equity round typically spans multiple long documents. As a result, notes can be executed quickly and legal costs are usually significantly less. If a company is raising $250K or less it does not make sense to spend $10K–$15K or more on legal fees for a fixed price round. Legal fees for a convertible note round are typically on the order of $5K.
Ability to reward early investors. There are several mechanisms for rewarding investors who come into the deal early, in addition to the general accumulation of interest over time. These can include a discount rate on conversion, a valuation cap, or some combination of those factors (each of which will be discussed in detail). It is also possible for the earliest note investors to get higher discounts and lower caps than subsequent convertible note investors.
For example, the first investor in a startup might get a 25% discount and a $1M conversion cap on their note, while an investor who comes in two months later could get a 15% discount and a $2M cap.
When a startup is trying to get its fundraising going it can be helpful to create inducements for the early investors. And as an investor, if you have faith in the company early on you can reap rewards for taking on the extra risk of being first in.
Delay in valuing the company. Generally speaking, convertible notes allow the company to delay setting a pre-money valuation on the company. For a very early-stage company it can be challenging to convince investors that the company is worth $5M, for example. By issuing convertible notes, setting the valuation can be delayed until the first priced equity investment, by which time hopefully the company has made more progress. The valuation cap, discussed below, effectively puts an upper limit on the value if it is included in the note.
While there are many benefits for founders, some founders and investors believe that convertible debt creates a misalignment of incentives.
Angel investors used to complain that convertible notes prevented them from getting fairly compensated for taking on the added risk of investing in a very early-stage company. A priced round by contrast would allow them to lock in a low cost for their shares. With the popularity of the valuation cap* as a feature of the convertible note, that argument has largely been addressed; but some investors still do not like notes.
From an investor’s point of view, sometimes convertible debt can be better than a fixed price equity round, because:
Debt sits on top of equity; meaning, if the company goes defunct, debt holders are entitled to be paid first, before equity holders.