Things You Need To Know About Convertible Debt for your business

Jenny Richards By Jenny Richards, 8th Jun 2017 | Follow this author | RSS Feed | Short URL http://nut.bz/2gyqped-/
Posted in Wikinut>Money>Investing

A common misconception with convertible debt is that debt holders are investors. They are not. Debt holders expect a repayment of the capital and interest as agreed

Things You Need To Know About Convertible Debt for your business


Are you a startup? Are you looking for financing? This means that you have heard of debt and equity financing methods. The truth is, running a successful startup is a big challenge, especially when you have to deal with late payments and stocking and restocking.

As you get deep into financing matters, you will come across a third fact, convertibles. You can either have convertible debt via notes or convertible equity through stock.

Unfortunately, you cannot access any of this from your traditional bank because you do not have a credit history. At the same time, you may not be able to determine the value of your equity. Like many other startups, you will be wondering about where to access seed funding from.

Thanks to increased competition and changes in financing methods, there is an effective solution – convertible debt notes. These were invented for startups like yours to access affordable equity without any need for valuation. Since its introduction, its use has been on the rise and it is the most common feature of startup seed rounds. More than two-thirds of startups use convertible debt for funding.

Convertible debt may or may not have a cap on the valuation. Cap is basically the maximum price of a deal. The cap ceilings are variable. The importance of caps on valuation is that the early investors in your company get into any upside and they also get a guarantee for a minimum percentage of the company’s equity.

The main features of convertible notes include:
1.Discounts
Discount rates are set by investors and founders. The minimal discount of between 10 percent and 30 percent isn’t a big drawback because the valuation will increase and even exceed the discount allowed. The discount is a reward to an investor who takes up the biggest risk investing in your startup.
Since the convertible debt holder looks for a high discount rate while youare after a lower interest rate, you will have to strike a balance between the two. You have to find a way of making the investor see an appealing investment opportunity in front of them.
2.Caps
The conversion cap is the reward given to early investors who take up the disproportionate risk of investing in your business. It is different from discounts in that the cap sets the maximum value of a company as the first leg of investment closes. This gives the earlier investors an advantage.
As you look at the valuation cap, you will have to keep in mind the two factors applicable to capping. The first thing is the value that is used to determine the equity portion the convertible debt holder will have in the future.
Secondly, you need to consider the cap value that sets the ceiling on all pre-money valuations. A higher cap translates to a lower percentage of equity owned by the convertible notes holder. The contrary is true. As a proficient entrepreneur, ensure that the valuation cap matches market deals in your current stage of business.
3.Interest rates
Just like business consolidation loans and other non-equity funding methods, the lent money is charged an interest. In convertible debt, this amount is agreed upon annually and is applicable from the date you receive the interest. The interest rate charged ranges from 4 to 8 percent. The investor has to think about this as a better or worse scenario.
4.Structure and format
Convertible debt, just like ordinary notes, has an interest rate, an issuance date, and a maturity date. However, its repayment is in terms of equity unlike conventional banks and lending institutions. The discounts incentivize investors but shock founders.
5.Prepayment
Since most convertible debt holders look for the potential of becoming future convertible equity holders, they will enforce measures to prevent prepayment of the note.
6.While there has been a rise in the use of convertible debt, most people preferonline consolidating companies since there are no restrictions and penalties on prepayment.

7.Terms of note
This is the document that addresses what happens on expiry of the note. This is when the note needs to be paid in full in case no capital is raised. This amount represents the principal and the interest.

Benefits of convertible debt
•The main benefit of convertible debt is that it protects you from giving up too much equity at any point, especially when you are looking for flexible ways of funding the business.
•You may therefore argue or factually say that a convertible debt is a security that makes it easy for your startup to obtain funding in a flexible manner

A common misconception with convertible debt is that debt holders are investors. They are not. Debt holders expect a repayment of the capital and interest as agreed. Some convertible debt holders look for potential to become equity holders. This is because being a debt holder is risky and you may be pushed out by convertible equity investors later on. Since equity holders look for ways of holding a bigger share in a lucrative startup, a mix of convertible debt and convertible equity creates undesirable dynamics for the startup’s future investment ability.

So, what who are convertible equity holders and which are the features of sconvertible equity?
Convertible equity is a new form of security that enables your startup to get access to flexible financing. These securities are modeled into convertible notes and the holders don’t require repayment. Since the holders are looking for stake in your startup, there is no interest accumulation.

Features
• The main feature of convertible equity is its attractiveness. It has less delays and contentions, and agreements are drawn easily.
• It is the perfect alternative for startups considering financing in the business’ early stages and seed capital, and short-term financing needed to get your business through an unexpected financial crisis.
Should founders be cautious about anything?
• Investors’ need for higher preference – they will ask that their money is paid back before everyone else’s.
• Little value addition from investors and their reduced incentive to help
• Low discipline because there is little or no government regulation – consider having a board.
• “Full-Ratchet” – this is where the convertible note comes with a cap or a ceiling but lacks a floor. In this case, if there is a down round, equity reprices.
• Lost allies – the notes have fewer rights and they create room for disenfranchisement.

In conclusion, be cautious about the discounts and the caps. Take note of the convertible notes’ multiple preferences. Though there are many complications, the convertible debt note lacks control provisions.

Tags

Business Plan, Debt Consolidation

Meet the author

author avatar Jenny Richards
I am a highly creative marketer who can always be trusted to come up with a new approach. I know that the client’s business comes first, and I never try to impose my ideas on others.

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