Everything you wanted to know about convertible notes.
When Sprint Pirates first decided to invest in companies with convertible notes we didn’t expect so many questions around them. Many of these questions revolved around the terms, but also the reasons behind why convertible notes and not straight equity. In this post I will look to share as many insights from the feedback we have received to give you a better understanding of this practice.
Convertible notes have been widely used in early-stage investment, they have several merits when being bench-marked with equity investment. In short, it’s a FASTER, FAIRER and CHEAPER way of closing an investment.
The negotiation processes of angel investors and early-stage investor is exhausting, and discussion around the appropriate valuation is one of the most drawn-out. The earlier the start-up is, the more difficult it is for us to give a fair valuation, so investing for equity is always a long conversation.
The great thing about convertible notes is that it postpones the valuation discussion, and allows the future equity investor to decide the company’s valuation based on more traction and growth. It is with this traction and growth that investors and entrepreneurs are able to give an appropriate valuation to the company without over or under-valuing it. Legal documents for convertible notes are far simpler than traditional equity investment agreements, in addition there are fewer clauses and are much more straightforward. At Sprint Pirates, we normally close the paperwork within 5 days after sending out the note agreements to the startups.
Due to the valuation discussion being postponed entrepreneurs have a much longer timeline to prove the real worth of the company, and it works for both sides! In many cases, entrepreneurs feel like they are being bullied and see investors as taking advantage of young companies. While on investors side they hate seeing entrepreneurs being so conceited thinking they are starting the next Dropbox or Facebook. Yet under the structure of equity investment this discussion about valuations cannot be avoided. It is in both parties interest to begin these investor relations without the long drawn out struggles of valuation with one another.
Majority of the equity investors at the early-stages do not enter into the same agreement as common share owners, instead there are many preferences attached with their capital injection, starting from liquidation preference to anti-dilution clauses etc. In order to make sense of these terms is to engage legal services which can be costly and timely. We do not see the value in such an early-stage company spending thousands on legal advice when the budget is just not there and most, if not all, of the capital should be focused on what really matters, traction and growth.
NOW, how to understand a convertible note agreement?
Firstly, convertible notes are loans. They will therefor increasing the liability side of your balance sheet. But instead of paying it back like you would any other loan the ‘convertible’ part makes it a hybrid investment.
What is a ‘valuation cap’?
Almost every convertible note contract has something called a ‘valuation cap’, ours is £1,000,000. This simply represents: the highest valuation investors are ready to convert the loan into equity. For example, the investor writes you a convertible note of £100,000 with a valuation cap of £1,000,000. When it comes to conversion (e.g. your next equity investment round), it will convert at the valuation (with a discount, see below) that is the same as the equity investors are receiving if it is below £1,000,000; however, if your valuation is above £1,000,000, the investor’s conversion will be capped at this valuation level.
This is where we received the most questions from our applicants.
Where did you come up with the £1,000,000 valuation cap?
At this early-stage of your company's growth it is very difficult for us to offer a higher valuation due to your limited growth. The £1m cap gives both us and you an opportunity to prove your companies valuation by converting to equity at your next raise. We, as pre-seed investors look to invest in company's with little to no traction or growth, that's where we add the most value. We don't invest in anyone with higher valuations at this stage.
Something I don't include in my answer:
If you think your company worth more than £1m you are most likely not in our investment range and should look to more institutional investors or angels for your next raise.
What is a ‘discount’?
A discount is a common element within convertible notes. This discount is traditionally set anywhere between 15% and 40%, depending on the maturity of the company. We see convertibles in early stage companies have a higher percentage discount to reflect the risk of the investment. Sprint Pirates sets its discount at 25%.
So how does it work?
If you have a convertible note of £100,000 sitting on your balance sheet with a 25% discount. It is simply means that when your next equity investment is happening, the convertible note holder gets 25% discount on the valuation of your next round. Therefor if your next round’s valuation is £1,000,000. Instead of getting 10% (=£100,000/£1,000,000); your convertible note holder will get 13.3% (=£100,000/(£1,000,000*0.75)).
How about the repayment terms?
Repayment terms vary between agreement, however one thing in common is it is an unsecured loan. An unsecured loan is when your company becomes insolvent or bankrupt investor will simply write off the loan and there is no obligation to repay. However, convertible notes still rank higher than equity, so in the event of a default when the company goes into liquidation the remaining assets are to be distributed to convertible note holders before any remaining assets are paid to equity holders. In addition, many investors (especially super early-stage investors like Sprint Pirates) demand a clause called ‘Change of Control’, meaning in the event of change of control of company before conversion, investor can demand a repayment of outstanding balance. Why is that? Simple — we invest in people, we see lots of ideas every day however it is the group of people who can execute which makes the idea worthwhile. So for our security we want to stay in with you and you alone, this is where the change of control comes into practise. If you decide to give up running your company you may be liable. So what if you decide to quit tomorrow and hand over the reins to someone else we may want out also.
Everything we do at Sprint Pirates follows one single principle: being founder friendly. We put in minimal protection clauses to protect our investment and leave the meaningless discussion to later.
Founders who go through our program should be aware that the only thing to keep boosting your valuation is traction and growth, and a friendly investment format can give you more time to focus on your already hectic product and market road-map.
Looking forward to perhaps having the pleasure to work with you. If you have any further questions about the convertibles don’t hesitate to shoot us an email at email@example.com or leave a comment below.