For the past decade or so, early-stage startup founders have increasingly turned to convertible bonds and convertible equity instruments to structure investment rounds, particularly in their initial fundraising. While some in the angel investment community have argued that it would be best if founders did fewer convertible bond rounds and more equity transactions, it’s important to consider why the convertible bond structure has garnered so much attention in the world of early-stage financing in the first place. What are the key benefits for founders and their investors in choosing a convertible bond offering over an equity offering? In future posts we will cover the most important terms and conditions, to consider for your convertible bond offering. But first, let’s look at the key benefits of the convertible bond structure to determine if it’s right for your business.
If you’re a founder, you might be wondering, “What’s wrong with, say, just selling 10% of my business to an investor and paying $100,000 to get us started?” This raises the first problem that convertible bonds are designed to solve, and that is the problem of valuation. Let’s say your company hasn’t generated any revenue yet, is still working on the beta version of its product, or maybe is looking for its first corporate customer. At this point, does it make sense to give the company a post-money valuation of $1,000,000? Maybe, but what if you ended up getting a lot of traction with that $100,000 and raising a Series A round two years later, valued at $10 million? Your first investor will be delighted, but you will feel serious seller remorse for giving away so much of your business for what you now know to be an extremely low valuation.
The main advantage of a convertible bond is that it allows founders and investors to postpone the valuation discussion until another day. Convertible bonds will be converted into equity based on the valuation of the company’s next round of equity financing. So, using our example above, instead of receiving 10% of the company in exchange for $100,000, the investor would convert to the round that values the company at, say, $10 million and a 20% discount. From the founder’s perspective, the company was able to gain the traction with the $100,000 to justify a higher valuation and avoided dilution by selling equity at a valuation of $1 million. The convertible bond investor, meanwhile, is happy because he’s being compensated for the added risk of getting in early with a discounted purchase price in the new round. While other investors are willing to pay $1.00/share for the company’s shares, the investor is treated as if they were buying the same stock at $0.80/share.
The second reason traditionally used to justify convertible bonds is simplicity . Returning to our example, the founders want to sell a 10% equity stake in their company. What are the terms of this initial $100,000 investment? Does the company sell common stock or preferred stock? If the company sells, do the proceeds of the sale go back to the investor’s money first, or do the founder and investor split the entire proceeds 90/10? What happens if the company raises capital on better terms in the future? Will the investor get these better terms or be able to participate in the new offering to avoid dilution?
Issuing a convertible bond in lieu of company shares again allows the founders and the investor to defer these decisions to the company’s next round of equity funding. The convertible bond investor will simply convert into the share class offered in the next equity financing and will generally receive the same rights (with certain exceptions). Given this simplicity, offering a convertible bond is generally less expensive than assembling an equity financing round. With this in mind, however, it is important to remember that both types of offerings involve the issuance of a security and in both cases you must consult with an attorney to ensure compliance with federal and state securities laws. Additionally, the angel financing community has matured to the point where there are commonly agreed terms for initial financing offerings for convertible bonds and initial financing stocks, reducing negotiation complexity for both types. While it’s generally true that convertible debentures are simpler to design, costs aren’t always vastly different than stock offerings, and external factors — such as who your investors are and how much bargaining power they have — play a significant role in the overall complexity of the project. which reduces negotiation complexity for both types. While it’s generally true that convertible debentures are simpler to design, costs aren’t always vastly different than stock offerings, and external factors — such as who your investors are and how much bargaining power they have — play a significant role in the overall complexity of the project. which reduces negotiation complexity for both types. While it’s generally true that convertible debentures are simpler to design, costs aren’t always vastly different than stock offerings, and external factors — such as who your investors are and how much bargaining power they have — play a significant role in the overall complexity of the project.
There’s no doubt that convertible debentures have been a nice addition to the early-stage financing landscape, particularly for founders, as they allow them to raise capital efficiently without granting rights typically reserved for preferred stock investors. Although convertible debentures postpone discussions about company valuation and preferred shareholder rights, these decisions will eventually have to be made. As such, convertible bonds are best viewed as a bridge to best position the company for a larger round of equity funding.
This article is for general information only. The information provided should not be construed as formal legal advice or the establishment of an attorney-client relationship.
