Before we get into private equity investments, it is important to be aware of convertible debt. A convertible loan, also known as a convertible note, is a short-term debt instrument often used in the early stages of a start-up’s life cycle. It is a loan from an investor that can convert into equity, usually preferred shares, during a subsequent funding round.
Subject to the loan being repaid (and sometimes the investor getting to elect to either have the loan repaid or an equity conversion), the conversion usually happens during the next investment round, at a discounted rate relative to the price per share in that round. The discount compensates the convertible loan holder for the increased risk they bore by investing earlier.
Convertible loans are employed in early-stage investments for a variety of reasons. They allow start-ups to avoid a direct valuation. This can be helpful given it is challenging to accurately value a start-up in its early stages due to a lack of operational history or steady cash flows. Instead, the convertible loan agreement defers the valuation until a later date when more information is available (i.e. in a subsequent equity financing).
Convertible loans are often faster and less costly to execute than equity financings. Traditional equity financing requires extensive negotiation and legal work around terms like valuation and control rights. In contrast, convertible loans bypass many of these complexities.
Despite their benefits, convertible loans also present challenges for founders. A significant issue is the potential for dilution of the founders’ equity when the loan converts into shares. This dilution can be substantial if the company’s valuation at the next round is lower than what the founders anticipated. The terms of a convertible loan can also create conflicts between founders and early investors. For example, if the conversion discount is high, or if the note includes a valuation cap (a maximum company valuation at which the loan can convert), this can lead to substantial dilution for existing shareholders (often founders, friends and family).
There is also the risk that if the company does not raise additional capital, or have sufficient cash flow, it could be stuck in a situation where it is obligated to repay the loan in cash but doesn’t have the capital to do so. Even if it does have the capital, the repayment can be a significant drain on a young company’s resources, which in some situations may not even have started earning revenue yet.
One benefit to founders, however, is that early investors with convertible loans do not have the same voting rights as those who own equity. This could mean that such investors have less say in the company’s decision-making, although they’ve taken on risk at an early stage.
While convertible loans can provide an efficient way for start-ups to raise initial capital, founders must be very careful of the potential pitfalls. It’s crucial to engage in careful planning and negotiation when structuring convertible loans, keeping in mind the impact on the company’s future capital structure and governance.
There are many potential pitfalls for founders using convertible notes. For example, assume the investor also wanted a first ranking security interest on their loan, if there was no conversion of the debt and the investor had a right to demand repayment, the company could be forced to hand over its assets (such as IP, inventory and the like) in return for repayment, a risk explored above.
In the next post we will focus on raising private growth stage investment capital from private accredited investors, private equity and venture capital firms.
John Wires
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