What's a Convertible Note - 7 Things Startup Investors Must Know about Debt Financing
First, some things you need to know: an angel capital group provides investment money at the earliest stages of a company. The company may only have an idea and a business plan. Startup investors of this type help the initial stages of a company’s effort to get going. There is some confusion about what are angel investors compared to what is venture capital.
Venture capital firms invest private equity funds as investment companies. They invest in startups after the money contributed from the company founders and others such as an angel investment group. After the “seed” round of financing, the venture capitalists come in with more investment money to help build up the company.
Second, if you do decide to invest with a private equity fund or venture capital group like our team at Angel Kings, you've got to know what a Convertible Debt or Convertible Note is. Often, startups raising funds will use this debt instrument to raise capital for their startup.
How to Invest Money (Know the Terms)
There are alternative ways to invest in a company besides making a simple equity investment. Some investors prefer making a loan to a company that carries an annual interest rate, which allows, at some point in the future, the debt to convert to ownership shares in the company.
Convertible Debt Definition
Convertible debt allows the bondholder to exchange the debt obligation for ownership shares in the company. Usually, this option to change a debt into stock ownership in a company is at the discretion of the convertible bondholder.
In essence, convertible debt is a loan that includes a stock option provision. The lender watches the stock valuation carefully and makes a decision at the appropriate time, when it appears that owning stock in the company is more valuable than the proceeds from a loan made to the company.
Companies like convertible debt, because the interest rate is less than a regular loan, when the lender has to option to convert the loan to a certain amount of stock. The lender pays for this value enhancement by charging a slightly lower interest rate on the convertible debt.
7 Things Startup Investors Must Know About Convertible Note Debt
George Deeb, who writes for Forbes Online, notes that it is important to understand the difference between preferred shares, convertible debt, and venture debt.
Preferred Stock vs. Common Stock - Most equity investors want to have preferred shares rather than invest in common stock. Preferred stock has a better position than common stock. Typically, investors holding preferred shares get a 6% to 8% annual interest on the investment. They also enjoy a preference in any liquidation, where they get their investment money back, before any distribution to common shareholders.
Discount Convertible Note - A discount convertible note is the reverse of preferred shares. Preferred shares are equity investments that pay interest. Convertible notes are loans with the option to change into equity. A discount convertible note allows investors to convert the note to shares at a price that is lower than the share price paid by others in the next financing round.
Interest Rates Convertible Notes - An annual simple interest rate is typical for convertible notes. This interest accrues over time. It accumulates and adds to the total amount of the loan paid back at the end or is part of the valuation when conversion to shares occurs.
Valuation Cap Convertible Note - A conversion value cap is a way to reward investors who hold the convertible notes. The maximum value of the company is limited to the cap in terms of how many shares in the company the convertible note holders receive upon conversion. Even if the company is worth more, the calculation uses the cap, which results in the convertible note holders getting more shares. Sometimes there is both a discount and a cap. In that case, the lower share price from the two calculations determines the share price for the conversion.
Convertible Note Warrants - A warrants gives the investor in a convertible note the right to buy a certain percentage of the next financing round. This is a deal “sweetener.” Sometimes the purchase price for the shares is set when the investor makes the investment by convertible note.
Forced Conversion - This comes from provisions in the convertible note agreement that cause the conversion into stock to happen automatically.
Venture Debt - Venture debt differs from convertible debt in that the assets of the company are the collateral, sometimes with personal guarantees of the owners. Venture debt does not participate in any upside of stock ownership or conversion into stock.
Conclusion about Convertible Notes and Investing:
It is important for founders of startup companies and investors in convertible debt to understand the variety of ways to structure these deals. Setting up an investment using convertible debt is easier and less expensive, in terms of legal fees, than an equity investment. There are advantages for both the company and investors with convertible debt, which makes it a popular form of financing a startup.
Learn more about Convertible Debt, Notes and 10 Ways How to Invest in Startups