Today,
we are in the golden age of startups, where people are ready to take risks for
their dreams and passion. It takes more than just a great idea to run a
successful business. Entrepreneurs and existing business owners need capital to
pursue their dreams. New business ventures often have difficulty obtaining
capital (whether for starting up, or for expanding operations). Today during
economic downturns where standards for commercial investment are becoming water
tight, a number of investors often seek non-traditional investment
opportunities to enhance their portfolios. A convertible note (“Note”)
provides such an opportunity to serve the needs of both the startup business
needing capital and the investor seeking an opportunity.
With
the latest RBI Notification dated Nov.07, 2017, FDI is also permissible by
means of Convertible Note
‘Convertible Note’
is an instrument issued by a startup company evidencing receipt of money
initially as debt, which is repayable at the option of the holder, or which is
convertible into such number of equity shares of such startup company, within a
period not exceeding five years from the date of issue of the convertible note,
upon occurrence of specified events as per the other terms and conditions
agreed to and indicated in the instrument.
A
short-term debt that converts into equity or to be repaid in cash. In the context of a seed financing, the debt
typically automatically converts into preference or equity shares upon the
event of a Qualified Financing. In other words, investors loan money to a
startup as its first round of funding; and then rather than get their money
back with interest, the investors receive preference or equity shares based on
the terms of the Note.
Qualified
Financing: Most (if not all) Notes contain an automatic
conversion clause that dictates the automatic conversion of the convertible
debt upon a “Qualified Financing.” The Qualified Financing is typically defined
as an equity financing by the startup, for the purpose of raising capital, in
which the aggregate of pre-determined amount is purchased by investors. Thus,
the Qualified Financing event is the trigger by which the convertible debt will
automatically convert to equity. The conversion is considered “automatic”
because it does not require the vote of either the startup or the investor.
As
a sweetener to the investor, Notes have a conversion discount feature by which
the Note holder will exchange the debt/investment for Qualified Shares at a
price per share equal to 80% (this amount can very per deal) of the price per
share paid by the Qualified Financing investors, so the Note holder gets more
shares for their investment.
One
of the key advantages of Notes is that the valuation issue is kicked down the
road until the Qualified Financing – when there are a lot more data points and
thus it’s much easier to value the startup (i.e., price the round). Again, a Note is a loan (debt, not equity). A
valuation of the startup is thus unnecessary; and, if there is no valuation,
there are no problems of dilution, taxes and option pricing. With startups and
small companies, investors may not be financially savvy enough to properly
value a company. By using Notes, investors can forgo valuation until a later
date when more sophisticated investors value the company and inject additional
equity. Therefore, a Note allows companies to access potential equity financing
with the lower upfront costs and efforts of debt.
Recently
a lot of startups have been using more Notes in angel rounds as they make deals
close faster. By making it easier for startups to give different prices to
different investors, they help them break the sort of deadlock that happens
when investors all wait to see who else is going to invest.
Note
allows more flexibility in price as valuation caps for startups aren’t actual
valuations, and Notes are cheap and easy to do. So you can do high-resolution
fundraising: if you wanted you could have a separate Note with a different cap
for each investor.
Are
Notes an easy way or does it tout the startups?
Notes
have a maturity date upon which the company can be forced into bankruptcy if it
hasn’t closed a financing round. Convertible equity eliminates that
threat. This is true in theory but extremely rare in practice. Unless the
startup has been hoarding cash or investing it in hard assets in some unusual
way, calling the Notes won’t yield any proceeds to the investor. Sometimes
aggressive investors will ask to control the board of directors or other things
upon a payment default.
Notes
accrue interest from the date(s) they are issued. This adds cost and
administrative complexity, especially with multiple closings on different
dates.
Yet
startups have cranked out thousands of Notes for startups over the past several
years, without any signs of the apocalypse (yet). Convertible equity strikes
largely as a solution in search of a problem. The primary reason is that
investors have every incentive to work with the startup to extent or
renegotiate the terms of the notes, because that represents their best shot at
seeing any return on their investment.
There
can be different structures for raising funds by startup, however, a startup
should look into the options which is best suited for your business.
To
know the further details about Convertible Note, Raising Funds by Startups and
other legal aspects of startups, contact us at admin@equicorplegal.com
/ +918448824659
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