Angels are increasingly doing convertible debt deals. While not all angels are well-versed in this funding mechanism (or just plain don’t like it), this deal structure is popular on the West Coast and catching on with entrepreneurs and angels who want more options for funding promising startup companies.
Angela Jackson, managing director of the Portland Seed Fund, has significant experience using convertible notes to fund startups. Approximately two-thirds of the fund’s investments are in convertible notes, and she says they have produced better returns to date than priced seed rounds in the portfolio. She helped demystify this option for me and explained some newer twists that may make it more interesting to angels reluctant to invest in convertible notes instead of priced equity rounds.
First, some basics. A convertible note is a short-term loan that converts into equity when a startup raises their next round of funding, often in 12 to 18 months. The note defers the company’s valuation to this next round of funding. Other provisions in most convertible notes include an interest rate (typically 8 percent to 10 percent) and maturity date, a cap on the valuation price for note holders when the loan converts to equity and a discount rate on the share price when the note converts. Many notes also include innovative terms that add more options for investors and align the interests of the entrepreneur and investors. More on those later.
Let’s walk through these key provisions in a little more detail:
- Discount rate: establishes how much note holders are compensated for the additional risks they take for supporting very early-stage companies. If the note is executed with a 20 percent discount, the investor receives a higher return. Jackson offers this example: "If in the next round investors are paying $1 per share, the note converts at $.80 per share. On a $100,000 convertible note, the note buys the investor 125,000 shares, which is effectively a 25 percent premium. That is fair reward for coming in early."
- Valuation cap or “Conversion cap”: protects early investors from high valuations in the next fundraising round. With a conversion cap, the maximum valuation for the next round is set at a certain level, say $4 million or $5 million. This prevents investors from having their shares diluted if the next financing round is much higher, say $10 million or $20 million.
"In the past angels haven't liked convertible notes because without conversion provisions they were taking a lot of risk without the potential for reward," Jackson says. "As valuations get crazy, angels don't do as well if they put a little money into a $500,000 convertible note and the company does its next round at $20 million pre-money valuation. The angels' money won't convert into a favorable number of shares under those circumstances, yet they made it possible for the company to get there. An entrepreneur and angel friendly compromise is to set the conversion cap at around $4 million, which gives angels more security. Angels will own a lot more of the company even if it is valued in the next round at $20 million."
Provisions make convertible debt friendly to both entrepreneurs and investors. Investors receive a fair reward for coming in early to risky deals and these innovations offer terms with more options.
New market innovations in convertible notes add even more options and upsides for investors. One provision allows note holders to convert to equity if the company is acquired before the note converts. Investors use a 1X or 2X liquidation preference to get a return in this case. For example, if an angel invests $25,000 with a 2X liquidation preference, the return would be two times his or her money if the company is acquired early.
Another new innovative option is to convert to common instead of preferred stock once a company is acquired. This enables angels to stay with the company as it grows. Jackson says “I think entrepreneurs and investors at this early stage need a variety of options, because everybody who tells you they know what's going to happen is lying. With options you increase the range of scenarios under which both parties can prosper."
Building awareness of how innovations have revitalized convertible debt takes time. Some angels remain staunchly against it, and Jackson questions whether they're aware of the newer protective provisions used in notes. "Most people against convertible notes come from the old days," she says. "It's the difference between building a house with hand tools versus power tools. These conversion provisions that started over the past three years really changed the game for investors."
She offered a creative solution from a deal she recently viewed. The West Coast company was backed by investor groups from different US regions. They were raising on a $500,000 convertible note, but it had a provision that if $750,000 was raised, it would automatically convert into priced equity at a $3M pre-money valuation. “That incents the angels who don’t want to be in a note to corral other investors to get it over the threshold,” says Jackson who added, “more cash to execute, in a reasonable time frame, at a fair valuation and terms. What’s not to like?”
What kind of deals you do is really about personal style and how comfortable you are with a period of uncertainty about company valuation that comes with using convertible debt – and a few other important factors I will cover in part 2 of this article. I'm based in the middle of the country, which tends to be much more conservative than the coasts. I'm seeing fewer convertible debt deals than angels on the West Coast, but I have put money in a couple convertible note deals. My advice? Keep learning more and decide for yourself if convertible debt is right for you and the deals you're offered.
