If your early-stage startup is like most companies in their infancy, you likely need capital for operating expenses, to accelerate growth, or for a variety of other business needs. To raise capital through investors, you can follow two paths: debt funding by issuing a note, or equity funding by selling an ownership stake (stock or membership interests) in the company. Ultimately, both paths lead to giving up a portion of your company, but the process of getting there for each is very different. Convertible Notes are more attractive because they don’t require the company to establish a value, provide quick access to capital, and are less expensive than an equity round.

This article focuses solely on raising capital through debt. For the equity side of raising capital, stay tuned for a follow-up article.

Raising capital through debt is typically done through a Convertible Note, which is very similar to a conventional promissory note issued as a loan, but it gets its name from the noteholder’s ability to convert the loaned funds into equity at a certain defined point.

To understand how a convertible note is different from a conventional promissory note, there are a few important concepts that make a convertible note a distinct fund-raising tool.

First are the Conversion Triggers. These are specified events that cause the note to convert, such as: (1) a subsequent round of funding; (2) a M&A event (like selling the company or entering into a merger); or (3) the note reaches maturity. Any one of these conversion triggers may (depending on the terms) cause the principal and accrued interest to convert into shares of the Company. Upon conversion of the debt into equity – and sometimes depending on the conversion trigger – the noteholder will be required to sign a variety of documents to capture their rights and obligations as an owner (shareholder or member) of the company. These documents include a Stock Purchase Agreement, Voting Agreement, Right of First Refusal and Co-Sale Rights Agreement, and Investor Rights Agreement and are typically referenced to in the convertible note.

Second is the period in which the convertible note matures, referred to as Maturity. If no other conversion triggers occur prior to maturity, then the noteholder often has the option to (1) cash out their principal and accrued interest, or (2) convert that total sum into equity at the valuation cap or some other determined value. Depending on the company’s goals in their fund-raising journey, you may be offered either preferred or common stock, which will also be specified in the note. Most convertible notes typically have a shorter term to reach maturity – about two to three years – as most companies typically plan to raise more funds before or by maturity.

Third, upon the conversion trigger, the conversion price will take the Discount and/or Valuation Cap into account. Both are used as an incentivize for early investors that take the risk to invest. Once the noteholder elects or is forced to convert the note, they will be given a discounted price (through the discount or the valuation cap).  A typical discount rate would be 20%.  In other words, the note holder would convert their debt into shares at a price that is, in our example, 20% lower than the price of the shares being issued to new money investors at the time of conversion. The other important feature that may exist in the note is the valuation cap, which sets a maximum valuation of the company and at which noteholder’s loan will convert into equity. The valuation cap and the discount protect the noteholder from paying a higher share price that new investors are paying.  This is a reward to the investor for taking the risk earlier.

Finally, consider whether you fit under a Regulation D Exemption. As with all investments, you need to be careful not to run afoul of the Securities Act of 1933 which governs the sale of ownership interests in exchange for capital. Therefore, before soliciting investors for debt financing, depending on the number of individuals being solicited for a funding round and how much money you want to raise, you will need to determine who you can solicit and whether they must be accredited investors. This is where an experienced and knowledgeable attorney comes in handy.

Whether you are the issuing company or the noteholder, do not be misled into thinking that a convertible note is a straightforward instrument.  Entrepreneurs using convertible notes need to understand the terms and, perhaps more importantly, how the terms will affect the next round of financing and the dilution to the founders. Nevertheless, if you are a company that is looking to raise capital quickly without having to go through the upfront hassle of subscription agreements, private placement memorandums, or the complexities of seed round documents, a convertible note is a simpler (up front) approach than equity funding.

For any of your funding needs – debt or equity – we can help. Please contact us to set up a free consultation by calling 720-306-1001 or email info@doidacrow.com.