Legal
Want to raise capital faster and easier? Convertible Securities can be your secret weapon. These financial instruments offer a simplified path to funding, allowing you to focus on what matters most: building your business.
This guide will equip you with the essential information you need to understand and leverage the power of convertible securities.
What are Convertible Securities?
Imagine you have a brilliant idea for a new app, and you want to start a company to build it. You need money to hire developers, rent an office space, and market your app.
One way to raise that money is through a priced round, where shares are issued at a specific valuation in exchange for capital. However, determining a fair valuation for early-stage companies is a major hurdle, often involving extensive negotiation.
That is when convertible securities come to save the day: instead of immediately selling equity in your company, you can promise investors shares at a future date by issuing convertible securities such as SAFEs (Simple Agreements for Future Equity) or convertible notes.
Essentially, these convertible securities will work as short-term financial instruments that represent a transaction in which an investment made will convert into equity at a later date, usually during a priced funding round.
Why are they a good idea for startups?
Convertible securities offer several advantages for both startups and investors:
- Streamlined and affordable process: compared to traditional equity rounds, convertible securities are quicker and less complex to negotiate and close. This means less legal paperwork (and fees) and lower transaction costs.
- Deferred Valuation: one of the biggest challenges for early-stage startups is determining a fair valuation. Convertible securities postpone this tricky process until a later funding round, when you have more traction and data to justify a valuation. This avoids potentially undervaluing your company in its early stages.
- Flexibility: convertible notes and SAFEs offer flexibility in structuring the investment, allowing you to tailor the terms to the particularities of different investors over a period of time, instead of all at once.
- Maintaining control: by using convertible instruments, founders don’t immediately dilute their ownership.
Convertible Notes vs SAFEs: What is the Difference?
The most fundamental distinction between Convertible Notes and SAFEs lies in their legal structure: convertible notes are debt instruments, while SAFEs are not. This difference has significant implications for how they function.
A convertible note is essentially a loan to the startup. Like any loan, it accrues interest and has a maturity date – a date by which the loan must be repaid. However, instead of being repaid in cash, the loan converts into equity in the company. This conversion usually happens at a discount to the price of the shares in that future round, rewarding the early note holders for their risk.
The maturity date can create pressure on the startup to raise a priced round before the note comes due, as failure to do so could force the company to repay the loan in cash, which can be difficult for a cash-strapped startup.
A SAFE, on the other hand, is not a debt instrument. It is a simpler agreement that essentially establishes a promise between investor and startup that, in return for an advance in capital, equity will be given in the company at a future date. SAFEs do not accrue interest, and they do not have a maturity date. This makes them simpler and often faster to negotiate and close than convertible notes.
Because there is no debt involved, there is no risk of the startup being forced to repay a loan if a priced round doesn’t occur by a certain date. This lack of maturity date provides more flexibility for the startup.
These differences make SAFEs usually more founder-friendly, but investors may prefer the structure of convertible notes in some circumstances. The good news is that startups can issue SAFEs and convertible notes simultaneously, tailoring each instrument to the preferences and requirements of different investors.
How will convertible securities impact future funding rounds?
Convertible securities can significantly impact a startup's future fundraising efforts.
One key consideration is the valuation cap. This ceiling on the conversion price protects early investors from excessive dilution if the company's valuation increases significantly before the next priced round. However, a low valuation cap can become a liability when the company performs exceptionally well. If the valuation at the next round significantly exceeds the cap, the convertible securities convert as if the valuation was at the cap, potentially signalling to new investors that the company's true value might be higher than perceived. This can limit the amount of capital the startup can raise or influence the terms of the deal, as new investors may be less enthusiastic if they perceive previous investors undervalued the company.
The discount rate, which incentivizes early investment, also plays a crucial role. While a discount attracts early capital, a high discount rate can significantly dilute the ownership of founders and later-stage investors. New investors may be less willing to participate if a substantial portion of the equity is slated to convert at a discounted price to earlier investors. This can make it harder to secure new investment or force founders to relinquish a larger percentage of their own equity to compensate. The cumulative effect of multiple rounds of convertible securities, each with its own discount and cap, can create a complex and potentially problematic cap table as the company seeks larger, later-stage funding.
Finally, the choice of convertible security matters. Convertible notes, being debt instruments, accrue interest, creating a liability on the company's balance sheet. While typically paid in equity upon conversion, this financial obligation is still a factor for potential investors. SAFEs, on the other hand, are simpler agreements without accrued interest or maturity dates, avoiding this particular issue.
Contact LUNA for Tailored Legal Advice
Managing the complexity of convertible instruments and ensuring their terms are clearly documented and understood is paramount for smooth future fundraising. In essence, while convertible securities provide a valuable bridge to future funding, careful consideration of their terms and potential long-term consequences is critical for continued success.
While this overview provides a foundation, every startup's situation is unique, and the optimal approach requires careful consideration of your specific circumstances. Don't leave these critical decisions to chance. At LUNA, our experienced team of startup legal experts can provide the personalised guidance you need to structure your funding strategy for maximum benefit. Contact us today for a consultation to discuss your options and ensure you're setting your startup up for a successful future.