A popular funding instrument for very early stage financing is a convertible note. With this instrument, the investor loans the company money. In exchange for the loan the investor accepts a promissory note. The note will accrue interest at a high interest rate, perhaps prime plus 4% to 8% in today’s market. Principle and interest are due at some point in the future. At that time the investor can elect to convert principle and accumulated interest into stock in lieu of payment.
Typically the price at which the note can convert into equity is based upon a discount from the price at which stock is ultimately sold. The language may read something like: “The note and accumulated interest can be converted into common stock at a discount of 20% from the price of the next equity round of at least $250,000.“
What this means is the entrepreneur and the investor do not have to negotiate the value of the company today. Rather they recognize that at some point in the future the company will sell stock. When that occurs, they will use the price of that stock sale to determine the price at which the investor can convert from debt to equity.
The advantages to the entrepreneur are that she does not have to negotiate and accept a lower value on her company today when the value will likely be higher later. And, since convertible notes are simpler than stock sales they can usually be done faster and with lower legal fees than apply to stock sales.
Theoretically, the investor’s position is at lower risk than had the funds been invested in stock. But practically speaking, in an early stage company, there’s little difference between holding a note and holding stock. If the company fails, both will be worthless.
A convertible note has one very large disadvantage to the investor. His capital is at risk, but his upside is limited. If, for example, the company is able to sell stock later at a valuation of $2 million, the investor will convert at a valuation of $1.6 million (20% discount from the $2 million). This is likely substantially more than the investor would have paid had he insisted on purchasing stock rather than loaning the company money, even though his funds were at risk as if they were invested in stock.
For this reason many local angels do not participate in convertible debt offerings. They don’t like the risk/return ratio. However, a way around this is to negotiate a cap on the maximum value the entrepreneur will have to accept. For example, the above conversion language might be qualified: “The note and accumulated interest can be converted into common stock at a discount of 20% from the price of the next equity round of at least $250,000, or a valuation of $1 million, whichever is less.“
This provision allows the entrepreneur to gain the benefits of a quick and relatively inexpensive transaction, while preserving for the investor the full upside should the company be highly successful.
Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center (www.idahosbdc.org) at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is president of the Boise Angel Alliance (www.boiseangelfund.com) and a member of both of its affiliated angel funds. He is a principal in Loon Creek Capital (www.looncreekcapital.com), which assists angels in forming angel funds. He can be reached by email to firstname.lastname@example.org or by phone at 208-426-3875. A version of this post was previously published in the Idaho Statesman's Business Insider.