A primer on convertible notes, convertible securities, and equity

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Originally posted by fyspringfield

If this is your first time raising money, the mechanics of how investors buy into your company can be very confusing.  Here’s a quick primer on how investments tend to work in startup companies at the seed stage.

Note: this is super basic, and there are a lot more details that will not be covered here.

Equity

Traditionally, investors have invested in companies to receive equity, or shares in a company.  This is the easiest method of investing to understand as well as the most common way of investing worldwide.  Simplistically, if I’m an investor who is interested in buying a percentage of your company, I’ll offer you money, and you’ll send me a certificate indicating how many shares — how much of your company — I own.

The number of shares that I’ll own is based on the price per share that we had mutually agreed upon.  Let’s say there are 1M shares in your company, and let’s say I’m interested in buying some of these shares and have $100k to invest.  We first mutually figure out a price per share, and let’s say that the price we decide is $1 per share.  This means that I will receive 100k shares for my purchase (which is 10% of your company).  The physical manifestation of this investment is a certificate that says that I now own 100k shares.  Later, if you sell the whole company to Google at say $5 per share, I will earn $500k for a net gain of $400k.

The concept of equity rounds (also called priced rounds) is very straightforward. Investors worldwide are familiar with and are used to investing in priced rounds.  And as you raise money at later stages, you will most likely be raising equity rounds.

Once you find investors who want to invest and agree on the price per share, everyone knows just how many shares they are getting, and everything is clear.

But, legally, equity rounds can be quite expensive to complete.  Lawyers can charge as much as $10k-$30k (in the US) to draft and execute the legal docs for an equity round, and traditionally, founders are responsible for paying for this as well as investors’ legal costs!  I personally think this is ludicrous, but this is still common practice.  So, in the aggregate, it is possible that you may be required to pay as much as $30k-$50k to get an equity round done.  Newer VC firms, though, typically do not pass their costs to their startups, which is much more progressive.

Additionally, the legal docs around equity rounds typically specify a threshold that must be met before the round is complete.  For example, if a startup is raising $1m in a priced round, this means that the startup must find enough investors to invest (in aggregate) $1m into your company at specified terms within a certain time period.  If the startup is only able to find enough investors to commit to investing $700k, the startup receives NO MONEY, and the round does not get completed.  The results are binary.  You either raise your full amount or nothing at all.  This means that if you are doing an equity round, you need to run your fundraising process very well to ensure that you raise the money you want; your timeframe for raising this round is limited.  It also means that the time between when your first investor commits to investing and when you get your money can be quite long — it can take months!

Usually, an equity round is kicked off by a “lead investor.”  Typically, this lead investor decides the terms of the round and also invests the majority of the money that will go into your company.  That lead investor will also usually help you fill out the remainder of your round with other investors.  For example, let’s say you find a lead investor for your $1m round.  He/she sets the valuation of your company and terms of the round.  He/she may then invest say $500k, and he/she may help you find other investors who will make up the remaining $500k.

In the 1990s, your first round of financing was typically a Series A round between $1m-$5m.  Expenses were a lot higher just to get a company off the ground, and so even the first round of financing was large.  These rounds were typically done as equity rounds and were led by VCs, since so much capital was required. In addition, the legal costs were just a small drop in the bucket compared to these round sizes.

Convertible Notes

In the 2000s, however, the cost to start a software company decreased dramatically.  No longer do you need to set up your own servers in your office.  No longer do you need to build a lot of tools – many B2B SaaS companies and infrastructure companies can now do all of this for you.  So, startups started raising seed rounds — rounds that took place before a series A.

A few years ago, these seed rounds were typically < $500k, and most teams only did one seed round with angel investors — independent rich individuals — before raising a series A round.

Because equity rounds are much more suited for bigger financing rounds and are a slow way of raising money, convertible notes are better suited for raising these smaller seed rounds.  It just didn’t make sense to spend 10% of your round on legal costs and have to wait for months before receiving the money when the angel investors writing the checks were open to moving equally as fast as the entrepreneur.

Raising money on a convertible note is fast — you get your money as soon as an investor signs.  It’s cheap (there are a lot of convertible note templates on the internet).  There is no minimum amount you need to raise in order to get your money.

A convertible note is a simple document that is effectively a loan.  People investing on convertible notes would invest money, and in return, receive an IOU for that amount plus some level of interest at the end of some agreed upon time period (typically 1-2 years).  In some sense, angels began to act like banks giving entrepreneurs loans.

However, unlike regular debt, convertible notes had a special kicker.  Convertible notes allow investors the option of converting the money into stock at the next priced round;  investors essentially have the option to get their money back + interest OR receive stock when the company did the next priced round.

Technically speaking, when the maturity date comes around and the startup has not yet raised an equity round, an investor could call the note, which means he/she could ask for his/her money back plus the accrued interest for the duration of the note.  What happens if your maturity date comes up and you don’t have the money to pay it back and are not raising an equity round?  You can discuss with your investors if they’d be willing to extend the maturity date by a year.  This is quite commonly done, so don’t be afraid to ask.

Most Silicon Valley investors won’t call your note when the maturity date arrives.  This is because, if you have the cash to pay the note, it must mean that your company is doing well, so an investor would prefer to have equity in your company instead of the debt repaid in cash.  If your company is not doing well, you wouldn’t have the money to pay off this debt AND if you do, removing the money could cripple the company. So, calling the note is detrimental in most cases.

Outside of Silicon Valley, there are a lot of investors who don’t care and may call your note on the maturity date.  Be careful in choosing your investors — especially if an investor has never invested via a convertible note before.

So let’s say a startup raises an equity round from a big VC after raising a convertible note round.  How does an angel investor convert his convertible note into equity?  The convertible note specifies the mechanics in which the investor receives shares.  Those conversion rules, however, are conditional — the price at which a convertible note converts into equity during a priced round is dependent on the valuation of the equity round.  So, when an investor puts money into the company on a convertible note round, he/she doesn’t know how many shares he/she will receive until later.  This ambiguity is sometimes a deterrent to investing on a convertible note, especially outside Silicon Valley.

Lastly, because convertible notes are technically debt (even though most investors convert their notes to equity later in priced rounds), it’s unclear what the tax implications are for both investors and companies. At the advice of some accountants, some companies issue 1099s to their investors on the accrued interest — even when they are not paying their investors this accrued interest.  Other companies don’t do this because they are not actually paying their investors any money. On the flipside, investors will often pay taxes on this “accrued interest” even though they are not receiving any cash.  This is another deterrent to investors investing on a convertible note.

Convertible Securities

As a happy medium, both YC and 500 Startups created Convertible Securities.  Convertible securities have properties that are akin to both equity and convertible notes.

Convertible securities, in so many ways, act like convertible notes.  Like convertible notes, there is no minimum amount you need to raise to get your money; they are a cheap, free, and limited legal bill; and they can get signed quickly.

BUT, the biggest distinction is that there is no interest rate.  Convertible securities are not loans.  As a founder, you do not need to worry about investors asking for their money back because there is no maturity date, and investors do not have to pay taxes on any so-called accrued interest.

That said, convertible securities are still new and a lot of investors are unfamiliar with this format of investing. Also, there is still the ambiguity about the price per share at the time of signing, which may make some investors feel uneasy.

All in all, this is probably my favorite format of raising money at the seed stage.  More later on the details and nuances of some of this.

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