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What is Convertible Debt & Why do startup raise money through convertible notes? Advantages

To understand convertible bond in startup context, we need to first understand it in the general sense. And in general sense these bonds are issued by big companies to reduce their debt burden. Recently more startups are raising seed money as convertible bond to reduce the hassle and to escape from the nitty gritties of issuing equity.

What is bond ?

A big company having high debt may issue bonds to raise money to pay off its debt. People buy these bonds to get interest on their investment. The company fixes a maturity date at which it will pay back the money and till then it pays interest annually/semi-annually/monthly which can be somewhere around 4%-10%. Based on the entity issuing the bonds these are called as corporate bonds, municipal bonds, and Government Treasury bonds, notes and bills, which are collectively referred to as simply “Treasuries.”

What is Convertible bond? (investor point of view)

Instead of cash back at the maturity, the investor has an option to convert the investment to get equity/shares of the bond issuing company. This is advantageous to the investor as he has both the option, either to get back this initial investment or to convert the investment to share (if the company is doing good at the time). The amount of stock that a bondholder can acquire is subject to a pre-determined formula. (ex- 10:1/20:1 – 10 bonds equal to one share of the company etc)

Ex: Imagine a public limited company is issuing convertible bond for Rs.100 each with an option to convert the bond-to-shares at a formula 10:1, agreeing to give interest of 5% annually. If you as an investor buy 10 convertible bonds for Rs.1000, you get an annual interest of Rs.50. If the company’s current stock price in market is Rs.600, you will not have any benefit to exchange your bonds for shares as you get 1 share for 10 bonds(for Rs.1000 instead of Rs.600).

But however in the future date if the company performs better (stock price goes beyond Rs.1000), then you may exchange the bonds with shares and get better return on your investment. SO the investor has both the advantage of getting the annual interest + option to go for equity exchange in the future.

Convertible-Debt

But Why do startup raise money through convertible bond? Advantages

Let’s say as a startup you want to raise debt based funds, as you don’t want to give away equity at the early stage.  You find out that the interest rates to raise a loan are too high(bank loans starts at 14%) So to reduce the interest rate on your loan you include an embedded conversion option in the bond. Other advantages are –

  • If you sell equity, you dilute your shares immediately. Issuing converts lets you delay the dilution.
  • It also puts off the valuation question to a later date
  • Much quicker to put together a convertible debt financing than to go about legally distributing the shares/equity
  • Historically convertible debt has been easier (and therefore cheaper) to put in place.
  • In the meantime, ‘your financial situation may improve or you may raise another round of funding’ and you can generate the cash needed to pay back the converts and prevent dilution.

Key Terms included in the convertible note agreement

  1. Interest Rate – This is the interest rate at which the loan is taken. Typically ranges from 5%- 14% annually..
  2. Maturity – The loan matures at the end of which the company is supposed to close the loan by paying back the loan in cash or converting the remaining balance to equity in the company. Maturity period can be from less than a year to several years.
  3. Discount – This is the Advantage for the investor for their early investment. A discount of 10% – 20% is given to the investor during the conversion. Discount on price per share of the next equity round and sometimes there is a valuation cap, often ranging from $6-8 million, which sets an upper limit on the conversion price. This makes the note offering more attractive to investors who are coming in at a risky time.
  4. A conversion cap – a pre-determined formula at which debt is converted to equity in the future. (ex- 10:1/20:1 – 10 bonds equal to one share of the company etc). A note converts into equity upon the next round of financing (usually the Series Seed or Series A Preferred Stock round) ‘OR’ upon sale/merger of the company, the note will be repaid (at either the outstanding principal amount or some multiple of the outstanding principal amount (e.g. 2 times) plus accrued interest. Some notes will permit the holder to convert into equity upon a Change of Control as well.
  5. Control of Note Holders – This is to protect the investors conversion rights in the future based on the investments they have done they will be able to amend the agreement and pre-payment terms. When working with multiple convertible note investors, it is often a good idea to provide in the note purchase agreement that a majority of note holders (based on their investment amounts) can agree to amend the terms of the note.  It is often the case that the terms of the note need to be amended (for example, upon the note maturing without a qualified financing, or in the case of subsequent investors seeking to change the terms of the notes in the prior round).

With the rise in popularity of convertible debt, there are many helpful resources available online. You can explore more on Convertible notes on the following links

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