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 kevinlearned@boisestate.edu
or by phone at 208-426-3875. A version of this post was previously published in the Idaho Statesman's Business Insider.
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