Recently, we’ve noticed quite a few Irish early stage businesses using convertible notes as the medium for their seed investment rounds. With the SEIS & EIS schemes proving to be so popular, many UK investors aren’t used to seeing this approach, so we thought we’d take the opportunity to walk through what a convertible note is and why you would use it as a option for an investment round.
What is a Convertible Note?
A convertible note is a short-term debt facility that converts into equity at a future date, usually pegged against a future funding round. The investor or fund is loaning the business money and instead of receiving that money back plus interest, they receive equity in the business. The outstanding balance of the loan is converted to equity at a specific milestone, usually at the valuation of a future funding round. Typically, there will be additional clauses within the convertible as incentives to the investor or fund such as discount rate, valuation cap, maturity date and interest rate.
- Discount rate – The valuation discount an investor or fund receives relative to the new investors in the follow on financing round
- Valuation Cap – This caps the price at which your convertible notes will convert into equity and providers convertible note holders with an additional protection to the extend the company raises its next round at a valuation which exceeds the valuation cap
- Maturity Date – States the end date of the convertible note when the company has to either repay the loan or raise the follow on funding. This clause limits the time has a company has to raise its next round of funding in order to convert your loan into equity.
- Interest rate – Convertible notes typically have interest as a further incentive for the investor or fund. However, as opposed to being paid back in cash, this interest can be accrued as additional principal, increasing the number of shares issued upon conversion
What are the Pros to Convertible Notes?
No Valuation Needed
The main pro to issuing a convertible note is that it does not force the business to set out a valuation which can often be a hugely subjective matter for pre money and early stage businesses.
The structure of a convertible note is designed to benefit those investors willing to take the risk of investment before traditional valuation metrics can be applied around revenue and customers. The business can then set out a favourable discount rate for the investors at which they can convert their loan, plus accrued interest into equity at a reduced price relative to the new investors in the follow on round. Additionally, if the business set out a valuation cap on the convertible note, the investor will be able to convert their investment into equity at a preferential price per share.
Keeping it Simple
Convertible notes are often faster, simpler and cheaper than traditional equity ‘priced’ rounds where actual ownership stakes are sold. Conversely, convertible notes are a form of debt, so there is no need to create a second class of shares thus avoiding complications around company valuations, stock options and tax implications.
What are the Cons to Convertible Notes?
Lack of Influence
Noteholders are at the mercy of future investors who will determine the valuation of the company. Additionally, if convertible notes are uncapped, the interests of the issuer and the noteholders are not aligned when it comes to a valuation as issuers want to the valuation to be as high as possible while noteholders want the opposite.
Some investors and funds prefer priced rounds as it brings with it certain rights as a shareholder such as voting rights, control rights, pro-rate rights and liquidation preferences.
Further Reading and Examples
Seed Invest have put together two articles that examine convertible notes in further detail along with worked out examples of convertible notes. Here are the links to the two articles – Convertible Note | Examples and How It Works and Convertible Notes.
You can also read Seedrs’ article for more information on how convertible loans (ASAs) work and what the benefits are.