Raising funds for your new startup can be tremendously stressful. You’re literally giving away a part of your company, and the transaction, if it can be called that, is rarely ever simple or transparent. There’s legalese, corporate jargon, and dozens of seemingly small clauses that can affect how your company operates and grows well into the future.
One particularly perplexing subject for entrepreneurs is the decision to raise money through the sale of equity or raising debt via convertible notes, and which one is more suitable for their early-stage company. (For the purpose of simplicity, I will only reference these two funding vehicles, given that they’re by far the most common when raising from institutional and angel investors for early-stage companies).
Raising through equity is arguably more well-known, and far simpler to understand: an entrepreneur determines a fair market-value for their company, creates a class of stock that brings with it ownership proportional to the amount paid per individual share, and sells those shares to investors.
Raising through debt, or convertible notes as they are often referred to now, is a little trickier to understand. An investor essentially tenders a loan to an entrepreneur for his company, complete with a maturity date and interest rate. However, unlike normal loans, which are expected to be fully paid with interest, convertible notes do as the name implies: the loan essentially converts into equity, usually at a future financing round or upon reaching maturity, and at a predetermined valuation, i.e. the valuation cap.
For example, in an equity round:
Entrepreneur raises $100,000 for equity into his company, which he conservatively values at $900,000. At a post-money valuation (i.e. the intrinsic value of the company, plus investment raised, or in this case $1,000,000), $100,000 amounts to 10% of his company.
But in a convertible note round:
Entrepreneur raises $90,000 in the form of a convertible note, with a simple annual interest rate of 5% and at a valuation cap of $1,000,000. In two years, he raises a new round of funding, valuing his company at $5,000,000. The convertible note, after two years, is now $99,000 resulting from interest, and converts into equity at a $1,000,000 valuation, not the $5,000,000, due to the valuation cap. This amounts to roughly 10% of his company.
See? It’s a bit trickier. But there are definite advantages to convertible notes. Indeed, Golden Gate Ventures use convertible notes for most of our investments: they’re more flexible than equity, easier to draft, quicker to get investors on board, and when done correctly, they can equally serve the interests of both the investors and the entrepreneur.
My next posts will dive into these advantages in greater detail.
Of course, all entrepreneurs are different, and their fundraising is often dictated by circumstances. The best advice would be to raise money as easily and painlessly as possible from reputable investors that will help you grow and succeed. If you can do that, then it doesn’t really matter whether you raise through equity or debt, especially in the long-run.
Ready for the next step? Let's learn more about when you should start seeking funding for your startup.