Financing is the most important part of any startup’s journey. However, debt financing is usually not available as banks deem startups to be not worth the risk. Therefore, many would-be business owners turn to equity and the capital markets as an alternative source of finance.
Venture capital funds are part of the capital market ecosystem, and by default they now insist on shares in the prospective startup company, as part of any equity financing deal. However, this can take many forms. Two of the most common investment structures used in early stage companies nowadays is convertible debt and preferred stock. Here, we will examine the differences between the two structures, and evaluate which is suitable for both startup owners as well as investors.
This kind of debt is held in an instrument known as a convertible bond or convertible note. These instruments are a type of bond that the holder can convert into a specified number of shares in the issuing company, or for cash of equal value. It is a popular vehicle in startup financing as a form of debt that can be converted to equity in a future investing round. Therefore, it is a hybrid security, with features of both debt and equity financing.
Convertible debt tends to work well for companies when the company can demonstrate high growth potential at the conversion-triggering equity round. Companies seeking to finance their early stage via convertible debt are normally given a high valuation, and can expect to hit that valuation quickly, while also being able to negotiate a high price cap (or no price cap at all).
The use of these instruments are also fairly easy and cheap. Additionally, the debt treatment of the investment keeps the company’s fair market value down, which has tax implications for compensatory equity awards. Convertible bonds also provide asset protection, because the value of the convertible bond will only fall to the value of the bond floor (however in reality if stock price falls too much the credit spread will increase and the price of the bond will go below the bond floor).
Preferred stock is a type of stock which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument. Like convertible bonds, preferred stock is also considered to be a hybrid financing instrument.
The terms of preferred stock are normally set out in a company’s articles of association. These special terms may be preference in dividends, being a preferential creditor in case of liquidation, or higher dividend yields. In exchange, holders of these stocks may not have any voting rights. Preferred stock may or may not have a par value associated with it. This represents the amount of capital which was contributed to the company when the shares were first issued.
When a startup undergoes several rounds of financing, it may issue several classes of preferred stock. Each class of preferred stock may have separate rights. Such a company might have “Series A Preferred,” “Series B Preferred,” “Series C Preferred” and common stock. Like other legal arrangements, such preferred shares may carry any dividend right or voting right imaginable, subject to negotiation.
Which is Better?
Traditionally, convertible debt is used at the earliest stages of funding, with preferred stock being utilised at the first round of financing. Convertible note agreements are also simpler and consequently cheaper to execute at the seed funding stage. That means the financing can get done relatively quickly, saving the company time and money on legal fees, compared to a typical Series A or other equity financing round. However, from a founder’s perspective, investors may request aggressive convertible note terms, for example investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders etc.
In cases where convertible debt is used at the seed financing stage (where the convertible notes also do not have a price cap), angel investors lend a specified amount of money to the company, and in the event that the company manages to reach its first significant round of venture capital financing, or Series A funding, the investor converts the outstanding amount of the note (principal + interest) into equity at a pre-defined discount.
This engages a strange phenomenon that puts the interests of the business and the interests of the investor against each other until after Series A financing. The higher the startup’s valuation is at Series A, the less equity the note will purchase. In other words, the better the company does before Series A, the less the angel investor owns. Other things being equal, the angel is better off with a lower Series A valuation, because they will own a greater equity stake at conversion, and the business is better off with a higher valuation, because it’ll keep more equity and/or be able to raise more capital. After Series A, they both benefit from increased growth.
However, angel investors can get around this issue by setting a price cap for the convertible instruments. With this, angels are protected against the company’s value increasing too much before Series A. With a capped note, the investor can convert at the discounted Series A price or the capped price – whichever is more favourable for the investor.
Consider the following mathematics:
Let’s say your seed investors purchase a convertible note (debt) with a 20% discount off the Series A share price. If you eventually sell shares in the Series A for $1 each, the seed investors will convert their debt to equity for $0.80/share.
Now, let’s say your seed investors are willing to buy equity for $0.90/share instead of buying debt. Should you sell debt or equity?
You should sell debt only if you can use the money to increase today’s share price by over 25% before the Series A financing. Otherwise, sell equity.
In this example, debt is worthwhile if you think you can sell Series A shares for over $0.90/share × 125% = $1.125/share.
However, let’s say you decide to sell debt in your seed round and you raise a Series A at $2/share. After applying a 20% discount, your debt investors pay $1.60/share for their Series A shares. In this case, it is better to sell debt to your seed investors in the seed round instead of selling them equity for $0.90/share.
In short, convertible notes are quicker and simpler, but risk-averse investors looking into a company with an uncertain valuation should stay away from it. Alternatively, preferred stock gives investors the peace of mind of a guaranteed dividend, investors don’t receive capital appreciation when a company does well. It will depend on the risk appetite of the investor, and the way the startup founder wishes to undertake the initial valuation stages of the company.