How Convertible Bonds Work in Early Stage Venture Capital
If you come from a more traditional finance background, you might be surprised at how converts are structured by angel / early stage investors.
Many angel investors exclusively invest in startups with convertible bonds, so it’s important for entrepreneurs to understand how they work. At its core, a convertible bond is debt that has the option to buy into the next round at a discount. Although terms are negotiable, as of now a “typical” angel convert carries an interest rate of ~8%, and a discount to the next round of ~20%.
Here’s a Quick Example / Scenario 1:
If an angel makes a $300,000 investment into your new business via a convertible bond that grants a 20% discount in the next round, and then your business does well and you do a Series A round of $2 million at $1 a share then…
- Your total financing = $300,000 + $2,000,000 = $2.3m.
- The new VC gets = $2m / $1 a share = 2 million Series A shares.
- The Angel gets = $300,000 / $0.80 a share = 375,000 Series A shares.
(Notice how the Angel gets a 20% discount on the share price to compensat her for investing earlier — when risk is ostensibly higher. The higher the valuation that’s placed during the Series A Round, the less the angel owns on a proportionate share count basis. More on that later.)
Deferring the Valuation is Powerful:
The main advantage of this structure is that, unlike raising a seed equity round (usually through preferred shares), raising money through a convert doesn’t require a valuation for your company. This is the defining feature.
Not setting an explicit valuation makes issuing the convertible bond cheaper from a legal perspective, less complex, and faster. As many of you know, negotiating rights for equity can take a lot of time, especially if there are disagreements on the valuation of the company.
It also (and this is just my opinion) tends to make the initial convertible bond raise less dilutive, which is good for the entrepreneur who wants to maximize their equity ownership and their employee option pool. I think this tends to happen because the entrepreneur is able to both time the Series A raise (to an extent), and can “earn” a higher valuation during the Series A when there’s more clarity on their business.
How Does the Angel Do?
First, I have to admit.. coming from the public markets myself, I think it’s pretty awesome that convertibles are structured to come at a discount. This is not how things are done with normal debt / public market convertible bonds.
Essentially, angel-round convertible bonds are debt instruments at high yield interest rates (junk CCC territory at best) with an immediately 20% in-the-money call option conditional on a Series A. There’s definitely more “risk” in early-stage investing, but those terms are pretty darn interesting.
So that’s the good… and the (I almost wrote “bad” but it’s not really) interesting part comes in when you get into thinking about the opportunity cost of making a convertible bond deal instead of a preferred equity raise. From the angel’s perspective, if the future Series A round comes in with a valuation that is materially higher than what the angel expected, then they’ll own substantially less of the outstanding equity.
Here’s Another Example / Scenario 2:
If we take the example above, and we see that the angel makes a $300,000 investment into your new business via a convertible bond (20% discount, etc), and the Series A round gets done at $15m (let’s say again at $1 a share)…
- Your total financing = $300,000 + $15,000,000 = $15.3m.
- The new VC gets = $15m / $1 a share = 15 million Series A shares.
- The Angel gets = $300,000 / $0.80 a share = 375,000 Series A shares.
(Notice how the Angel’s proportional ownership stacks up against the new VC. This chart below doesn’t include the equity owned by the founders / employees but it’s useful to get a sense. The higher the pre-money valuation, the less the angel will own.)
Using Valuation Caps:
The better the company does in the following Series A, the comparatively worse the Angel does (they’re probably happy for the entrepreneur — I would be for sure!— but from a P&L standpoint it’s worse). Let’s flesh that out.
To borrow slang from the public debt markets, if the “discovered” pre-money valuation for a company is $100m, the Angel’s convertible bond gives them an option to convert into preferred shares at a 20% discount — or an equity valuation of $80m. If the Angel who saw potential in the company early on “created” the company at a valuation of anything below $80m, they would have come out ahead.
One way the industry has evolved is for Angel’s to include valuation caps, which put a ceiling (put a “cap”) on the valuation that the Angel is willing to convert into. If the valuation cap is set at $10m, then if the Series A is a home run and comes in at pre-money valuation of $100m, the relevant conversion point for the Angel is $10m — not $80m. As you can imagine, in a world with asymmetric payoffs, having these valuation caps is a powerful advantage.
Of course, there’s plenty of game theory involved, and if a VC sees these terms in the Angel’s convert, they may fixate on this valuation and you could be anchoring your company’s valuation around the cap rather than the arms-length / “fair” valuation for the company. It wouldn’t be the first time financiers used behavioral quirks to their advantage / disadvantage.
Hope this quick overview of converts helps!
I work as a research analyst at a mutual fund in Boston and write these notes for fun (not investment advice, doesn’t reflect the views of my employer). Would love to connect at: linkedin.com/in/jasonyum
