Convertible Venture Debt

What is Convertible Venture Debt?

It is generally in the form of convertible notes that are initially structured as debt but have provisions that can provide investors with the option to convert the principal and accrued interest to equity at the following equity round.

Typically used in the early stages of VC investments, convertible debt defers the company valuation to a later date, enabling quicker closure and lower legal fees for closing the investment. The typical term of the convertible note is between 12 to 36 months.

When is Convertible Venture Debt used?

Convertible debt is most useful in the early stages of a company when it is hard to quantify a company value, and the company is seeking investment to drive growth. An early-stage company will not have a credit history to help secure a traditional loan from a conventional lender. Additionally, the company may not generate cash for a while to make periodic payments. This makes early-stage companies look at equity financing. However, since the company may not have significant assets, revenues or customers, valuing a company for equity remains challenging. Further, the founders may not wish to dilute significant equity and give up control. This is where convertible venture debt comes in.

Convertible debt is a debt obligation that is not expected to be paid in cash at maturity, rather in equity. A key objective of a convertible note is to postpone the company valuation until the company has matured and has proved itself – typically at a qualified equity financing event.

Investors at this early stage may be individuals who know the entrepreneur (or the start-up team) or who have a professional connection to them. Given the investment is essentially cash without a confirmed value of how much the company is worth (at this early stage), it will most likely be by someone familiar with the company or industry or from seasoned investors who are comfortable with early-stage equity investing.

Key Terms in Convertible Venture Debt

Let’s look at some of the key terms in convertible venture debt:

Interest: Like any other debt instrument, the convertible note earns interest over a period of time. However, this is not paid in cash and accrues until maturity or conversion. It helps the Company conserve cash and also serves the interest of the investors by increasing their potential equity at conversion.

Maturity date: At maturity, typically 12-36 months, the notes and accrued interest are payable to the investors if they have not been converted to equity. Some notes may have provisions for automatic conversion to equity at maturity.

Conversion provisions: A convertible note allows investors to convert it to equity on a qualified financing event – typically an equity raise but could be an IPO or a sale. In addition to the accrued interest, there are provisions like a valuation cap and discount to compensate the note investors for the risks of investing earlier.

• Valuation cap: It represents a cap on valuation for the notes to convert to equity and is beneficial to the investors if the Company has a qualified financing event above the valuation cap.
• Conversion discount: It represents the discount at which the convertible note converts to equity in a qualified financing event.

Advantages and Disadvantages of Convertible Venture Notes

Some of the benefits of convertible venture notes are:

• Quicker and less expensive than an equity financing round.
• Delay valuation – attractive for early-stage companies that do not have proven offerings/revenue traction.
• No cash outflow on interest payments as it accrues in kind till maturity or conversion.
• Convertible notes are ideal for a company that needs financing between equity rounds.

Some of the downsides of convertible venture notes are:

• If a company can’t or chooses not to raise equity and the notes don’t automatically convert, it needs funds to repay the investors.
• The valuation cap and automatic conversion price essential act as a floor valuation for equity rounds.
• If the subsequent round provides a liquidation preference and includes note holders, new investors may negotiate if there is a large uptick in valuation.
• If the company is unable to repay the investors by the maturity date and if the investors opt not to extend, the investors can force the company into liquidation.

Example of Convertible Venture Debt

In this example we are going to look at three different types of convertible venture debt. Download the Financial Edge template to work through the answers and create your own spreadsheet for calculating venture debt conversions.

The example below provides some information about a convertible venture debt note. We are told that the initial investment is $50,000, paying zero interest and it offers a conversion rate at a discount of 20% and a valuation cap of $10 million.

Following this investment, we are told that there has been a further funding round where the company has been valued at $20 million and is offering 4 million shares at a price of $5/share.

Let’s look at three scenarios using this information:

Example 1 – Convertible Note with a Valuation Cap but no Discount

This first example would consider the conversion rate of the note if it had a valuation cap of $10m but without the discount. This new funding round values the company at $20m, which is above the cap in the convertible note so the investor would be looking to convert the debt into equity.

Using the valuation cap, we can calculate that the convertible note investor can convert into equity at $2.50 per share. This is 50% less than the rate offered to new investors thanks to the valuation cap in the note.

Thus, the note holder can convert the initial $50,000 investment into 20,000 shares (at the $2.50/share cap price). The 20,000 shares are worth $100,0000 (at the open market price of $5/share), which is a 100% return on investment.

Example 2 – Convertible Note with a Discount but no Valuation Cap

This next example looks at what the note would be worth if it had the 20% discount but no valuation cap:

The discount allows the noteholder to convert into equity at a 20% discount on the valuation. So, in our example it means they can convert at a share price of $4/share, which is 20% less than the $5/share offered to new investors.

Converting at this discounted rate would allow the debt investment of $50,000 to be converted into 12,500 shares worth $62,500 – a return on investment of 25%.

Example 3 – Convertible Note with a Discount and Valuation Cap

When an investor has both clauses in the convertible note, they can choose which option they prefer. In our example the best return would come from the valuation cap option, which offered a 100% return versus 25% return from the discount option.

However, it is worth noting that our example was based on the company’s valuation being significantly above the valuation cap in the convertible note. If the next funding round was valued much closer to $10m, say $11m, then it would have been more attractive to use the discount option. The discount option would have continued to offer a 25% return on a $5/share price, but the valuation cap would have only delivered a 10% return on investment.

Use the excel download to work through these examples and create sensitivity analysis on company valuations and discounts of your own.

Conclusion

Investors in convertible notes are sophisticated investors and realize that there is no assurance that they will realize a return on their investment and may end up losing the entire investment. In the absence of a future fundraising event, an IPO, or a sale of the Company, none of which can be guaranteed, the investor may not even become an equity holder. For the Company, it may do extremely well and raise equity way above the valuation cap. None of these are uncommon. When considering convertible notes as a seed investment, it is critical to understand all potential outcomes and their implications.

Additional Resources

What is a Venture Capital Analyst

Series A B and C Funding

Venture Capital Due Diligence Checklist