By Gary Miller – Managing Director, Consulting Division, SDR Ventures
In recent years, convertible debt has become a common financing vehicle used by entrepreneurs to fund early-stage companies, particularly tech startups. Convertible debt wasn’t always this popular, and there are more pros and cons (and complexities) to convertible debt than most entrepreneurs know. While this column is insufficient to discuss the many details and nuances of convertible debt, here’s a quick overview of the upsides and downsides of convertible debt, and what other alternatives might exist for your company.
Convertible debt is a hybrid: part debt and part equity. It functions as debt until some point in the future when it may convert to equity with some predefined terms.
Convertible debt generally has the following principal terms:
- Interest and payments: A relatively low interest rate (generally 6 to 9 percent). Typically, interest accrues “in kind” (meaning that the interest grows the principal and is not paid in cash) until the maturity date or conversion into equity.
- Term: Generally as short as six months or as long as two years maturity, but commonly in the 12-18 month range. For the entrepreneur, longer is better because financing always takes longer than you expect.
- Conversion into equity: Generally it converts during future equity financing. The event that “triggers” this conversion typically is called a “Qualified Equity Financing”, and is specified in the convertible note documents.
- Discount and cap: Since the holders of the convertible debt took an early bet on your company, typically they receive two principal benefits in relation to the investor who negotiates a later equity financing with you — the discount and the cap. The discount is the rate at which convertible debt converts into equity at a lower price per share than the equity investors who are purchasing shares. The cap is a promise that you won’t use the investor’s money to grow the valuation so amazingly high that the discount doesn’t adequately compensate him or her for their high risk, early bet on your company. The cap is negotiated at the highest valuation at which the loan may be converted.
Convertible debt has its upsides. It is widely known to investors and accepted by them. It is easy and quick to negotiate — the only major terms are the interest rate, discount and cap. A convertible debt transaction is quicker and less complicated than stock offerings. It also has lower transaction costs. An experienced transaction/securities lawyer that works with startups or early-stage companies on financing transactions has standard convertible debt documents, so there’s a good chance the transaction will cost you less than $5,000 in legal fees. Compare that with attorney’s fees for a typical venture capital preferred-stock deal that could run $15,000-40,000 — or more.
And there are some cons. You can easily end up with many early investors, since you’re often receiving relatively small checks from angel investors. If this is the case, it can be administratively messy when you bring in an equity investor who sets the conversion terms for all of those early folks.
If it doesn’t convert, the company must pay the money back at maturity, just like any other loan. And the maturity date may be uncomfortably short.
One early-stage tech company (for which I provided consulting services) that has had success with convertible notes is TekDry International. In the competitive Front Range startup market, TekDry founder and CEO Adam Cookson said investors seemed to prefer the convertible note “after they determined we had priced it fairly, and that we were the right team to be successful.” TekDry now is engaged in a major expansion with Staples throughout the country.
What about other possible funding options?
- A SAFE. This acronym stands for “Simple Agreement for Future Equity.” The investor buys the right to buy stock in an equity round when it occurs. It can have a valuation cap, or not, just like a convertible note. But the investor is buying something that’s more like a warrant, so there’s no need to decide on an interest rate or fix a term.
- Venture capital financing. Unless you’re Elon Musk, it’s virtually impossible to interest VCs in a Series A round before you can demonstrate significant commercial traction. Even with such traction, be aware that VCs fund only a small percentage of startups or early-stage companies.
- Revenue-based financing. This can be an easy and cost-effective way to grow your business that enables the founders to retain their control and equity position. The key is that you must have revenue to qualify for such financing, since revenue-based lenders get repaid from a percentage your revenue stream — like a royalty.
- Bank loan. Sadly, banks don’t like to lend to newer businesses that lack significant hard assets and profits.
Be aware of what you’re getting into when you plan out the funding path for your company. My advice to entrepreneurs is to always engage an experienced transaction/securities attorney and pay close attention to the terms and details.
Gary Miller is the Managing Director of SDR Ventures Inc.’s Consulting Division, where he helps middle-market private business owners prepare to raise capital, sell their businesses or buy companies, and helps them develop strategic business plans. He is a sought-after business consultant and speaker on M&A and capital market trends, what buyers are looking for in acquisitions and due diligence. He can be reached at 970-390-4441 or email@example.com.
To see Gary’s full article via The Denver Post Business, click here.