The common refrain among startups is that there is a shortage of funding options available to them. Banks won’t touch early stage companies due to the lending risk. But venture capital usually isn’t a choice either because most VC firms don’t invest in early-stage companies until they are further along, perhaps reaching a benchmark such as proof of concept or a prototype. Many startups get around that obstacle through convertible notes, a form of debt financing. But there’s a twist on this form of debt financing that a growing number of startups are choosing: convertible equity, a startup-friendly seed financing vehicle that is replacing convertible debt notes.
Convertible notes are loans that convert into equity when the company raises its first round of equity financing. When a startup is at its earliest stage, it can be hard for a company to arrive at a valuation. When the company’s value is hard to determine, it’s also hard for both founders and investors to determine the percentage of equity they’ll take in the company. Convertible debt offers a simple and straightforward approach to financing through deals can be completed in a few hours with a legal document that’s seven pages or less. Adeo Ressi, founder of TheFunded.com and the Founder Institute, told TechCrunch that he estimates that more than half of early-stage deals are done this way.
But convertible debt is not without problems. Startups must pay simple interest on the loan, which can become complicated to calculate if the seed round includes many different investors, each of them with a note that starts at a different time. This approach to financing works for a startup as long as the company progresses far enough to reach the point at which the debt converts to equity. But that doesn’t always happen. Ressi told TechCrunch that the percentage of debt-financed startups that go on to raise a Series A round is decreasing as new angel financing enters the market, and venture capital financing is only growing modestly. Without a successful Series A financing to convert that debt into equity, a startup could be on the hook to repay the loan with interest. That might be money that the company doesn’t have.
Convertible equity works differently.
Unlike convertible debt, where startups pay interest on the loan, convertible equity relieves the startup of the obligation to repay the loan, and the interest, when the debt matures. This equity may also be classified as “qualified small business stock,” which may have a lower capital gains tax rate, according to TechCrunch.
Convertible equity offers to startups some of the features of convertible debt without burdening these companies with debt. This is a route that BigFish Capital is happy to discuss with all nascent companies, even those that are only in the idea stage. Contact us today.