There are basically two ways that a startup can raise funding that we see over at LawTrades: (1) equity (stock), and (2) debt (notes).
The Funding Dilemma
Startups typically don’t have a credit history, which makes securing a traditional loan from a conventional lender (e.g., a bank) pretty much impossible. A company that’s in its early stages of formation will usually be unsuccessful in convincing a bank to loan it money since it’s an untested entity. This is why startups try to fund their initial operations with equity.
However, in order to sell equity, you need to know the company’s valuation. Since figuring out a startup’s value is usually impossible (it’s just starting up, so it typically doesn’t have any value in the beginning - no assets, revenue or customers), determining equity would be arbitrary. It would also impair a more fair assessment later, after the company does achieve positive cash flow.
So, if you can’t get a bank loan and you’re unable to determine equity, how do you access seed funding to roll out your startup?
Convertible debt notes were innovated to enable a startup without a valuation to raise capital quickly and less expensively than equity, and as a feasible alternative to obtaining a vanilla bank loan.
A convertible debt instrument is a loan from an early round private investor (angels or VCs). VCs and angel investors are high net worth individuals who offer startups private loans with the expectation that at some point later down the road (e.g., 1-2 years), the debt changes into equity ownership (stock) in the company.
They were pioneered to allow founders to get a quick loan from private investors, in exchange for promising to repay those investors with equity (stock) at a later time when equity could be determined - normally, after a Series A funding round. In other words, company founders get fairly quick, inexpensive (low interest) cash, which they repay with ownership equity at maturity.
What distinguishes a convertible debt note from an ordinary loan are two key characteristics: (1) the discount, and (2) valuation cap. These features change the DNA of a convertible debt note dramatically as a loan species.
Similar to ordinary notes, convertible debt notes contain an issuance date, interest rate and maturity date. Unlike conventional loans, repayment is with equity. It’s the valuation cap and discount that incentivize investors, and often bewilder founders.
The discount is a feature that rewards early investors for taking larger risks than later investors. It does this by offering them the right to obtain shares at a cheaper price than that paid by Series A investors, once the Series A round closes.
The conversion cap similarly rewards early investors for their disproportionate risk, but in a different way than the discount. The cap sets the maximum value of a company when Series A closes, again giving an advantage to earlier investors.
The discount and cap are features that offer early investors two different ways to value their original investment (loan) when the Series A round closes with a concrete valuation. One method will usually give the investor a higher rate of return than the other.
This is why convertible debt terms usually provide that the early investor has the option (after qualifying financing is received at the Series A round), to choose between the lower of either the discount or cap conversion. Though it sounds contradictory, it’s actually the conversion price that’s the lower of the two methods that results in more shares issued to the early investor upon conversion.
Many founders are often pretty perplexed about how convertible debt works, so we’ll start with a very simple example.
Here’s a basic model for understanding how the discount and cap features work: We’ll assume the founder wants to raise an initial $500,000. Founder and angel draft a convertible note for $500k, with a 20% discount and a $5 million cap.
Igniting the Discount
The 20% discount means that the investor can buy the stock - when it becomes available after Series A closes - at 20% less than what Series A investors can buy it for. If share prices were set at $1.00 / share, the discount would enable the debt holder to buy the same preferred shares at $0.80 / share, receiving more shares than what the Series A investor gets for the same amount.
The equation is fairly simple: it’s the investment amount / discounted price.
So using the above hypotheticals, it’s $500,000 / $0.80, which gives our early investor 625,000 shares, resulting in 125,000 more shares than the Series A investor receives for the equivalent investment. This translates into a 1.25x return, which you get by dividing the value of the number of shares received by the original investment: $625,000 / $500,000 (not including annual interest).
Engaging the Cap
Now we’ll assume that the Series A round sets a pre-money valuation at $10 million. What we’re doing differently here from the discount method is adding a valuation price ($10M), while still using the $1.00 / share hypothetical we used to illustrate the discount. We’re also still driving the basic model of assuming a $500k investment.
The way we calculate the cost per share (the conversion) using the cap valuation method is by dividing the cap by the pre-money valuation assessed during the Series A. Here’s the equation:
$5,000,000 (the cap contained in the note) / $10,000,000 (the Series A valuation) = $0.50/share.
Next, we take the $500k original investment and divide it by $0.50: $500,000 / $0.50 = 1,000,000 shares, which is 500,000 more shares than the Series A investors receive for the equivalent investment.
This translates into a 2x return, which you get by dividing the value of the number of shares received by the original investment: $1,000,000/ $500,000 (not including annual interest).
...Which is Why Investors Want to Have Both a Discount and (lower) Cap
You can play with the above variables to see how these features work. For instance, if the convertible debt didn’t have a cap in the above scenario, then the most the original investor would’ve received is 625,000 applying the 20% discount.
You can also find some other simple interactive tools that will help you gain a better understanding of how these different methods work. For instance, Shareware offers a handy calculator here where you simply enter an investment amount, discount rate and valuation cap and immediately visualize your conversion value and resulting ownership percentage. FundersClub has some additional numerical examples here, and Cooley GO provides some more hypotheticals and nice graphics here.
Of course, once you start adding founders and multiple seed round investors, things can get complicated pretty quickly. That’s why I suggest first understanding the basics as set out above, and then trying some of the online tools to crunch some numbers.