What are the benefits of raising money through a convertible debt financing?

• 2.19.2015

Your startup company is still in its infancy. In the first few months since founding the company you have built the beginnings of a great team, you have achieved a few important milestones in the development of your product and you have started to generate some buzz in your industry. You have accomplished much in a short period of time, but there is much left to do before you are ready for prime time. 

You need capital to continue the company's progress. You have been approached by a potential investor eager to make an investment in your company and you're facing the dilemma of how to structure the proposed investment. Should the company raise money by selling shares of stock, thereby diluting the ownership interests of the founding team, or would it be more advantageous to raise money by issuing convertible promissory notes—debt instruments requiring the company to potentially pay back the amount invested with interest? 

Selling Stock

In order to raise money by selling shares of stock, a company has to agree with a potential investor on the value of the company so that the number of shares to be purchased and the resulting ownership percentage of the investor can be accurately calculated. An equity investor interested in purchasing shares of stock issued by the company will likely insist on purchasing shares of preferred stock. Shares of preferred stock generally come with a number of preferential rights that put the holders of those shares at an advantage to the founders, the most important of which is a liquidation preference that entitles the holders of preferred stock to receive a specified amount of money upon the liquidation or sale of the company before the founders, or holders of common stock, receiving anything.

Other bells and whistles that are likely to accompany shares of preferred stock include preferential voting rights, redemption rights, anti-dilution protections and rights to participate in future financings of the company. These preferential rights require pages and pages of complicated documentation, which may require a significant period of time to negotiate and finalize.

Issuing Convertible Promissory Notes

By raising money through the issuance of a convertible promissory note, your company will likely be able to raise money more quickly and efficiently than may be possible in an equity financing, and most importantly the company can avoid a protracted negotiation over the company's valuation, as it is not necessary to determine the value of the company in order to complete a convertible note financing. Convertible notes do not entitle note holders to a specified ownership percentage or number of shares as does the purchase of stock. Purchasers of convertible notes are debtors of the company, not stockholders.

As a result, the company and the investor do not need to agree on a valuation of the company, which is likely difficult to do at this early stage of the company. The founders may believe that the company is already worth millions as a result of the strength of the team and the technology, while investors see a very young company fraught with execution risk that cannot possibly be as valuable as the founders insist.

By purchasing a convertible promissory note from the company, the investor is receiving a debt instrument that carries with it the company's promise to repay the principal and accrued interest thereunder at an agreed-upon maturity date. If, prior to the maturity date, a conversion event occurs (generally the company's consummation of an equity financing event that results in the company receiving an agreed-upon minimum investment amount), the principal and interest due under the note will convert into the equity securities issued in the conversion event financing. Generally the price per share at which this conversion will occur is determined by applying a discount percentage to the price paid by investors participating in the conversion event equity financing. Additionally, there is often an agreed-upon valuation cap that ensures that the note will not convert at a price per share in excess of the amount derived by applying the valuation cap. 

Which One to Choose?

In a convertible note financing, there are a limited number of terms for the company and the investor to agree upon (maturity date, interest rate, the parameters of the conversion event, whether or not the note will include a valuation cap, any special alternative conversion rights which may apply at maturity or otherwise, and how the note will be affected by a sale of the company prior to the repayment of the note). The more limited scope of negotiable terms applicable to a convertible note financing can make the documentation and negotiation process significantly less time consuming and less expensive than an equity financing. A convertible note financing may be the ideal means of raising capital where the valuation bid and ask between investor and company are too far apart and execution speed is paramount.