Understanding Convertible Notes in Fundraising
Updated: Aug 23
Traditional forms of private equity investments have been serving its intended purpose for a long time, and are therefore considered one of the most preferred methods of profit creation by investors. Debt Equity is yet another form of financing that companies and individual investors often prefer. Moreover, these investors and institutions are also looking at alternate investment instruments like venture capital funds, hedge funds, etc. as avenues for wealth creation. Investors with substantial knowledge of their domain does understand the benefits of diversification, and one of the most popular formats of alternative investments is private equity.
This segment includes angel investors, venture capital funds and private placement of public equity.
In the most conventional format, startups and small businesses at different stages of their growth cycle, raise investments via private investors to help build their businesses further, and in turn offer some equity stake in the company against its valuation. With the growing popularity of this format, another concept — venture debt — has become quite relevant, wherein investors offer businesses with startup capital as a loan, and charge a certain percentage in interest for the service. However, one of the most popular and widely accepted methods in the startup ecosystem have come to be known as convertible notes.
It is like a short-term debt that converts into equity, in conjunction with a future pricing round.
In simpler terms, an investor providing you with the required startup capital, Is Owed Unto (IOU) you make the payment back. In this case, however, the investor will receive a certain percentage of preferred stocks, under the covenants of a convertible note. The biggest advantage of issuing convertible notes is that at an early stage, the valuation of the business is pretty much "undefined", so the issuance of shares based on a valuation gets "complicated". Since early stage ventures entail a huge amount of risk, investors will look to obtain preference shares. Preference shares are not favored by startups as they would have to fulfill a ton of obligations to their preference shareholders and thus, they would rather issue convertible notes, which can meet the expectations of investors. It also helps the founders maintain its autonomy in decision-making as most convertible notes are preference shares, but don’t offer veto rights and board seats (which are designated to protect the rights of investors in case of a corporate action). Most importantly, convertible notes provide more flexibility in its terms for converting prospective investors, and closing them at different prices.
It is very simple, and cost-effective to issue a promissory note.
In 2013, Y Combinator — a startup accelerator introduced SAFE Notes.
Simple Agreement for Future Equity (SAFE)
The concept of SAFE is that it provides investors the right to convert their investments into equity at a later stage, or upon the completion of some future events like when funds are raised in a priced round. Investors will then receive shares in the next pricing / valuation round at a certain discount from the current valuation.
SAFE facilitates the transactions for an early exit and a valuation cap. It does not have a maturity or expiry date. It cannot be called a convertible note in the traditional sense as there is no provision for an interest payment and a maturity date.
There are four distinct types of SAFE:
In a most favored nation clause, if subsequent convertible securities are issued to future investors at better terms, the same will automatically apply to the investor’s SAFE.
In 2014, 500 Startups developed an alternative to SAFE with KISS
Keep It Simple Securities (KISS) - Agreement
KISS is more aligned with convertible notes and accrues with an interest rate, a maturity date and the option to convert into equity in the next series of funding. The objective remains the same i.e. to obtain funds with ease and low costs.
KISS investors are generally investing in the company at a very early stage, when there is still a huge amount of risk and hence includes a MFN clause to protect the investors from downside risk.
KISS has a 18 month maturity date and if the funding round capital is not met the KISS-Agreement holder can convert at the value cap by obtaining a majority vote.
There are two types of KISS:
Debt version includes an interest payment and conversion option.
Equity version does not contain an interest payment nor a repayment at maturity.
In 2019, 100X.VC introduced iSAFE Notes in India
India Simple Agreement for Future Equity (iSAFE)
An iSAFE is a convertible security note, and neither an equity nor a debt instrument. An investor and the founder can mutually agree on the investment amount, giving away the need for fixing a valuation. Once an investment is made, the authorised and paid up capital will have to be increased by the extent of investment.
Any outstanding iSAFE note would be referenced on the company’s cap table like any other convertible security. Investors will typically be granted a pro rata right to maintain their equity percentage.
There are five types of iSAFE:
Fixed conversion at a future date.
To comply with the provisions of Companies Act, defined by the Ministry of Corporate Affairs in India, iSAFE note takes the legal form of CCPS.
Compulsory Convertible Preference Shares (CCPS)
In India, the provision of future equity is prohibited, thus instruments like SAFE and KISS have not been able to gain any context within the startup ecosystem of the country. This imbalance brought in the concept of CCPS and is now the sole provider of convertible shares in the startup sector. These preference shares have to be converted into normal shares after a predetermined date, or triggered by specific events such as a priced / valuation round, closure of any Mergers & Acquisitions deal, or by an IPO.
CCPS is currently the most popular form of investment used by private equity investors in India. It is believed that more than two-thirds of private equity deals in India are now carried out using CCPS. These convertible shares provide investors with an initial claim to the company.
Investors link conversion with the growth of the company.
Startups keep the dividend rate of these instruments at minimal.
Remember that the latest class of CCPS has a higher preference than its preceding classes, when it comes to payout, i.e. a Series B - CCPS will have higher preference over Series A - CCPS.
Now let's understand this concept with examples.
(including the above mentioned terminologies)
Say that, Gray Matter Technologies is a research startup founded by two Caltech students, namely Walter White (50%) and Elliot Schwartz (50%). The company raised its seed round of investment for $500,000, by issuing a convertible note to Gretchen, with a max valuation of $5M, discount of 20%. The convertible note also set an interest rate of 5%, with maturity in 24 months.
After a couple of year into operations, they manage to attract the attention of Gustavo Fring, who is now willing to invest $1M at 20% equity. This event triggers the convertible note with Gretchen, who invested 2 years before Gustavo, making her total investment with an accrued interest rate of 5% at $550,000.
Alternatively, in just a year — they make a breakthrough and even gets nominated for a Nobel Prize for their work on molecular switches. The new investor, Saul Goodman is impressed with their growth and willing to make a Series A investment of $12.5M at 25% equity.
This event will trigger any outstanding convertible note, but in this case, however, Gretchen will have her valuation capped at $5,000,000 giving her an advantage!
In yet another Scenario, if they don't make any considerable strides but are healthy with stable growth metrics, the maturity date will give an option for Gretchen to convert her investment into a debt, repayable by founders in equal installments over a period.
In case of bankruptcy, once the investor execute the notes, whatever money is left after discharging all the liabilities (including compliances), will be returned to the convertible note holders in preference over the equity shareholders (founders) until they receive their investment in full.
Hence, such liabilities are on the company, and not on the founders.
Seed stage investors now prefer convertible notes as it provides the benefits of both lending and ownership, plus the investors are protected from dilution up to a certain limit (in most cases).