For Founders seeking cost-effective ways to raise capital, convertible notes (“C-Notes”) may be the way to go. They’re quick, simple and relatively cheap - but worth understanding before jumping in headfirst. Today we explain what C-Notes are and how they work, while debunking some common misconceptions along the way. Strap in, read on and learn if C-Notes are just the thing to get your start-up off the ground.
What are convertible notes and how do they work?
C-Notes are (typically) short-term hybrid debt and equity instruments. Put simply, they’re like an IOU between a start-up and investor. C-Notes allow investors to front up capital in the form of interest-accruing loans that, down the line, convert into Company shares. (This happens after a “triggering” event, which we’ll explain later on.)
One of the most compelling reasons to use C-Notes is for quick access to capital. Whether you’re on a capital-raising roll and investors are lining up to seal the deal, or if things are slow and your Company needs bridging finance before finalising its main equity capital raise, C-Notes provide a simpler, more efficient option. Free from lengthy negotiations around business valuation (always tricky early on), C-Notes can be gold for start-ups.
Is your interest piqued? There are five key terms to get across before undertaking a capital raise via C-Notes. These are: interest rate, maturity date, discount rate, valuation cap/floor and triggering events. Let’s discuss.
This is the amount of interest payable on the loan (or principal) that the investor makes to the Company. It is expressed as a percentage of the principal. Interest usually accrues until a conversion event is triggered or the C-Note matures. Then, the total principal and interest must be paid by the Company (in most cases, anyway) or converted into shares.
The maturity date is when the C-Note expires. If the C-Note has not converted into equity as a result of a trigger event (see below), the C-Note “matures”. On this date, the principal and interest become due and payable.
When C-Notes are used as bridging finance, the investor takes a risk by pledging support ahead of future investors (who put their money on the table at the close of the equity raise). As a reward for going out on a limb, you can offer the investor a discount.
The discount is typically a percentage reduction on the price paid by investors in the equity raise. For example, if your Company was in the process of raising equity at a valuation of $5 million dollars and offering a C-Note to prospective investors, say, 12 months before the anticipated close of the equity round, it could offer the C-Note investors a 20% discount on the $5 million dollar valuation. If the C-Note converts, it would do so at a Company valuation of $4 million. In other words, the C-Note investor will be entitled to receive more shares for their dollar investment than the equity-round investors. Enticing.
Valuation cap or floor
While C-Note raises are great for sidestepping discussions about valuation, some investors may insist on limiting their risk by imposing a valuation cap. This line-in-the-sand sets a limit on the valuation of the Company at the time of a triggering event. Pursuing this path usually leads to Founders negotiating a valuation floor, too: a minimum value that can be used upon a triggering event. A floor is appropriate where, for example, the Company has raised prior rounds of capital and has already had a valuation attributed to it.
Savvy tip: Think carefully before agreeing to a valuation cap. In some cases, you could lock up the value of your Company by agreeing to a valuation that is not consistent with that of later equity rounds.
These are specific, agreed-upon events that “trigger” either a repayment of the principal and interest, or convert the C-Note into Company shares. Examples of triggering events include:
- A successful capital raise that meets a specified threshold. For example, the terms of the C-Note might provide that: upon the successful equity raise of $500,000 at a valuation of $10 million, the C-Note will convert to equity.
- Sale of the Company or IPO.
- Appointment of a receiver, liquidator or trustee, or a commencement of a liquidation or insolvency proceedings.
Savvy tip: Have you decided who decides? An important commercial point to consider during a C-Note negotiation is the power balance: which party has the right to decide on triggering events (and by extension, the repayment of the principal and/or conversion of debt into equity)? Set clear rules around decision-making to avoid ending up in a tight spot if the investor wishes to have the C-Note repaid, but your Company doesn’t have the funds to do so.
Now that we’ve covered key terms, let’s pull apart some of the common misconceptions surrounding C-Notes.
Myth: Raising funds through C-Notes is much harder than equity raising.
This is simply not true. Equity raising presents a challenge to many early-stage start-ups because agreeing on a valuation, when data is limited, is a tricky business. Investors want a low valuation, while Founders want to sell high. Raising capital through convertible notes takes away much of this headache by postponing valuation discussions until much later when more data is available. This is not to say that there’s no negotiation involved. C-Note investors want to be compensated for taking a leap of faith and want a decent valuation cap and/or discount rate, so you’ll need to stay savvy and sweeten the deal.
Myth: Issuing C-Notes is very expensive.
From a time and cost perspective, raising capital via C-Notes is relatively efficient.
C-Note financing is usually cheaper than an equity raise because it’s simpler. To raise C-Note finance, all you need is a C-Note Agreement (which includes the C-Note instrument) and you’re ready to go. Finding investors is also not as difficult compared to other forms of capital raising. That’s because negotiations are less complex (again, because valuation discussions are generally postponed and parties don’t need to negotiate labyrinthine Shareholders’ Agreements) while the presence of interest on the principal makes the investment less risky, from the investor’s perspective.
Myth: Issuing C-Notes would make your Company less attractive to future investors.
Whether your start-up is attractive to future investors depends on the substance of your business. What does it do? Who are the leaders? What is the vision? What is the strategy? … This rule applies regardless of whether the raise is through C-Notes or traditional equity. The key is finding the sweet spot between rewarding early investors who have gone out on a limb to support your start-up, and ensuring future investors do not feel that they are over-paying for shares in your Company at the time that they invest.
When it comes to C-Notes, the key terms you’ll typically negotiate are the interest rate, discount and whether or not to have a valuation cap (and if so, the sum of the cap). Setting high discount rates and/or higher interest rates will generally reward the C-Note investor.
C-Notes are an exciting alternative to traditional equity, offering early-stage start-ups a simpler, more flexible route to financial support. When your figures and valuations are still a little fuzzy, C-Notes can get prospective investors across the line.
Still have questions on convertible notes? Pick up the phone to a savvy lawyer, on-demand, by joining Metis Law Platinum. Click here to find out more. Or contact us at metis_at_metislaw.com.au or on (02) 8880 9383.