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Fundraising 101: Equity versus Convertible Notes

Friday, December 18th 2020 (5 months ago)

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Raising money for a startup can prove extremely difficult, even under ideal circumstances. In the early stages of the process, the main question founders need to ask is “What type of equity do I want to raise?”

The two most popular methods for fundraising are equity or convertible notes. How do we know which one is right for our startup?

Equity expresses ownership in a company or asset. To raise cash for your business, you may sell equity to investors. Equity essentially represents the amount of money that investors and other stakeholders would receive in the event of liquidation or acquisition of that company (Investopedia).

For example, if I start a company I own 100% of that company. If I need additional cash to grow my company, I could sell a percentage of the business to investors. In theory, the cash would help my business grow at a faster rate and/or reach higher levels of growth, otherwise unattainable without that cash injection. In the end, all stakeholders profit based on their owned percentage of the company. Similarly, those investors take on a percentage of my risk by owning a portion of the company. If the business fails, they may lose some or all of that initial investment. This strategy is called raising equity.

Whenever you raise an equity round, you essentially sell off a part of the business, so you must value your company. For example, if I raise $1M, investors want to know exactly how much of the company they will own following that transaction. We need to know the value of the company to calculate investor ownership. This value is called the pre-money valuation.

If I determine a pre-money valuation of $4M, and I raise $1M of equity from investors, my post-money valuation equals $5M.

Post-money valuation = Pre-money valuation + Equity raised

To keep it simple, let’s assume I raised $1M from one investor. That investor will own 20% of the company following the fundraise.

Equity = Cash invested ÷ Post-money valuation

Investors may choose to invest in a company for equity to achieve a large return on their investment when you eventually sell your company. Other investors may see your company as a cash-flowing asset and desire a dividend if the company becomes profitable. Those investors will receive a percentage of net income, which may equal the percentage of their ownership in the company.

Founders may also compensate employees with equity, which can prove more profitable for your team than a higher salary if the business performs well and/or sells for a large amount down the road. Particularly in the early startup stage, you may not have enough cash to pay your employees the market rate salaries for their positions. Many larger companies like Amazon, Google, and Facebook also use this strategy to compensate their employees with stock units or equity.

This type of benefit serves as an excellent team incentive because the employee’s performance and tenure with the company directly impact their ultimate payoff. Equity aligns the interest of all parties toward higher business growth and a positive bottom line. The more the business grows, the more employee equity is worth.

Ultimately, when you sell equity, you lose your status as the sole owner of the company. On the other hand, you may gain exponential growth through investors or attain a more productive and more loyal team by sharing.

However, because raising equity requires founders to set a valuation for their startups, this strategy may not suffice for those in extremely early stages. Often, pre-market and pre-product startups engender extremely low valuations. The lower the pre-money valuation, the higher the percentage you must relinquish. For example, if I raise $1M, but my pre-money valuation equals only $1.5M, I must sell 40% of my company to those investors. That’s a huge price to pay, especially right out of the gate.

What other options exist when we need cash amidst a low pre-money valuation?

Enter the convertible note. Technically, a convertible note is a type of debt. Debt is typically paid back in the future, either in increments or in one large sum.

Conversely, we do not pay back equity to investors – when raising equity, investors achieve a return on their investment through dividends or a percentage of cash collected through eventual acquisition. The business does not pay the principal back. As such, equity engenders higher risk for investors because they will not reap a return on their investment if the business fails. As the value of the business decreases, the value of their equity decreases accordingly.

However, unlike traditional debt, the convertible note raises money in the form of debt but expects to convert into equity at a later date.

What exactly does that mean? When you raise money on a convertible note, you essentially create a piece of debt with specific terms, such as a maturity date or a due date. The debt will carry an interest rate and other debt-specific terms, but one key difference exists between the convertible note and traditional debt.

The convertible note contains provisions that allow conversion to equity at a specific point in time – this is called the qualified financing round. This round sets the terms of the note. Typically, the convertible note will convert to equity the next time you go to raise equity. Often, a stipulation within the convertible note indicates that the debt will convert into equity at a discounted valuation as per that qualified financing round.

For example, let’s say I raise $1M on a convertible note. The terms of the note indicate that the debt will convert to equity at the next qualified financing round at a 20% discount of the valuation at that time. Fast-forward to the next round. I raise my next qualified financing round at a $10M pre-money valuation. Because the convertible note will convert at a 20% discount, the investors essentially invested at an $8M pre-money valuation on that convertible note. This outcome is favorable for investors. Remember, lower valuation translates to a higher percentage of ownership.

As always, investors take on some risk with the convertible note. At the time of investment, the investors do not already know the valuation for that future equity round.

For example, say an angel invested $1M in my company in 2019 on a convertible. In 2020, my company gets a $100M pre-money valuation. Great outcome for the company? Absolutely. But the outcome is not so great for the convertible note holders. Remember, Equity = Cash invested ÷ Post-money valuation. Our post-money valuation is $100M + $1M invested. As such, the investor ends up with a measly .9% in equity. An extremely high valuation means minuscule percent ownership.

To mitigate this outcome, most convertible note holders choose to include a valuation cap in the terms of the convertible note. This means the note will convert at the lesser of the valuation cap. In this case, the investor might set a valuation cap at $10M. In this scenario, despite the pre-money valuation of $100M, the note would convert to debt at $10M, which sets a floor on the valuation and ensures investors achieve that percentage in the company.

Typically, we recommend that founders raise using whichever instrument allows them to gain traction and close the round. If some investors strongly advocate for equity and some for convertible notes, do not let the type of financing dictate the terms of the investment. Push for your preference, but ultimately utilize whichever causes the least friction with the round.

To recap, equity implies ownership in a company in the form of stock-like shares. The convertible note starts as debt but expects to convert into equity at a later date through the priced equity round. Equity requires startups to set a valuation immediately. Convertible notes do not, but instead require valuation at a future fundraise. As such, extremely early-stage startups may prefer the convertible note during their first fundraise. What will you choose?

For a walkthrough of equity versus convertible note terms, check out our channel on YouTube to learn more.

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