Financing start-ups: convertible notes
David del Valle Díez, lawyer in the Commercial Area. AGM Abogados
A convertible note is a type of financing that is increasingly used in the world of start-ups. Basically, it is a loan granted to a company in exchange for the option to subsequently buy shares in the company, when the first round of funding takes place.
The key to this instrument is making the investment in start-ups possible, even when the value of the shares in the first capital increase cannot be determined with certainty. Therefore, it is a high-risk investment in the project’s first phases and one of the usual types of financing used by business angels.
The convertible note grants a loan to the company, before the initial funding round, where the company’s first capital increase will take place by creating new shares. Nevertheless, the differentiating factors in this type of financing are as follows:
- Investors have the possibility of converting their loan and interests accrued into company capital once the first capital increase is made. If the capital increase is not carried out, the investors are entitled to receive the loan plus the interest.
- The so-called discount rate is the percentage applied to the valuation attributed to the shares at the time of the capital increase. Consequently, the investors that provided financing in the initial phases are rewarded and they are entitled to buy shares at a discount to the price offered to third parties in that funding round.
- The valuation cap is another option which can be included in a convertible note agreement, either independently or as a supplement to the discount rate. It stipulates the maximum value granted to the company’s shares in the funding round in which the investor’s loan will be converted. Investors in convertible notes will thus achieve a larger percentage of shares, avoiding their dilution in the company’s capital.
Below is an example of how a convertible note works:
- An investor pays €100,000 to finance a start-up through a convertible note.
- That financing is in the form of a loan, with an annual fixed interest of 5%.
- The maturity date is set for 24 months as the deadline for carrying out the first funding round, in which the capital increase will be made, where new shares will be issued with a value that has not yet been determined.
- The investor will be entitled to convert the amount of the loan and interests accrued into company shares, applying a 20% discount.
- The company’s valuation cap in the first funding round will be €500,000.
Imagine that a capital increase is carried out 12 months later, where the valuation of the 30,000 new company shares totals €300,000. In other words, each new share entails an issue premium of €9. In this case, the investor in convertible notes will be entitled to convert €105,000, applying a 20% discount, in accordance with the following formula:
€105,000 / 10 * 1-20%
Convertible note conversion amount / partition value * 1-discount rate
The initial investor will obtain 13,125 shares in the initial funding round, compared with the 10,500 shares that it would have obtained if it had taken part in the capital increase in which it converted its convertible notes. Therefore, the investor is rewarded for the high risk taken in its initial financing.
If there is a valuation cap that supplements the discount rate, the convertible note is usually converted at the lower value between the discount rate formula or that obtained by applying the cap to the valuation in the investment round. Therefore, it is essential to value both types correctly.
The main advantage of a convertible note as a financing instrument is its flexibility. It does not have the formalities that a capital increase requires nor the notarial and business register costs. The convertible note is a private loan that enables the parties to agree on any terms and conditions to supplement the legal framework of this type of investment. Remember that the investor does not have any economic or voting rights in the company until the capital increase is performed.
In any case, it would be advisable to negotiate, together with the convertible note, the basic terms and conditions of a future agreement with partners to provide certainty to the investor regarding the conditions applicable to the future partners. It would also be necessary to remember that, for accounting purposes, the convertible note is recognised in the company’s balance sheet as a debt because it is a loan.
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