Raising Capital: Friends, Family, and Convertible Debt in the Early Stages

“Fundraising is one of the most difficult parts of the startup world . . . (for) first-time founders this is an even more daunting process.” — Will P. Martin, @willpmartin

Last week’s post covered raising capital by selling conventional debt to friends and family (F&F) and why that isn’t a good idea. This week, we’ll flip the series into one of three methods of raising capital for your start-up that can put your company in a better position for growth.

Convertible Debt Basics

Convertible debt (CD) is a compromise between raising equity and raising conventional debt, giving founders and investors the best of both. In simple terms, CD is a loan that is converted into preferred equity in the future based on a trigger event—usually, the next equity round raise. The CD can include an interest rate, a discount to the next round valuation, and a valuation “cap”.

Convertible Debt Specifics

Here are some specifics about this instrument.

Amount

CD amounts are usually up to about $2.0 million. Since this capital will convert into equity, the CD amount should be no more than about 15% to 20% of your forecast next round of equity. If you raise too much capital in the CD round, it may take up a significant portion of the equity round when it converts, reducing the ownership percentage the next round investors receive and potentially nixing the deal. To this end, you may want to include a “qualifying round value” clause as part of the trigger event.

Interest

Since CD is a loan, it usually carries an interest rate of 5% to 10%. The interest normally accumulates and is included in the conversion to equity at the next round raise.

Discount Percentage

The discount, typically 20%, gives CD investors an incentive to invest in this early round, rewarding them with more shares than next round equity investors for the same amount of money invested.

Valuation Cap

A valuation cap is usually requested by more sophisticated CD investors. The cap sets the maximum pre-money valuation of the company at conversion, thereby defining the minimum equity ownership percentage the CD investor will own once the conversion is complete.

Here are the key pros and cons of raising convertible debt.

CD Pros

Faster and less expensive to raise capital, as there is less paperwork required than for a priced equity round.
Money can be raised in stages and used immediately; a one-time closing is not required.
Overall valuation discussions may be deferred until the next round raise.
Early investors get rewarded for their contribution with a discount or valuation cap.

CD Cons

Raising too much convertible debt can make it hard to raise your next equity round.
Considering a valuation cap may defeat some of the purpose for raising CD.
Complexities may arise if the next round funding takes longer than expected or doesn’t occur at all.

Key point: Although raising convertible debt may be faster and less expensive than a priced equity round, you need experienced counsel to ensure that it works to your advantage while avoiding potential problems in raising future rounds.

Summary

Raising convertible debt may be a good option to consider for your early stage, providing that you structure it well and are aware of the risks posed by this investment vehicle.

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Do you need advice on how to raise capital? Are you considering what type of investment to use and how to raise the money? Schedule a one-hour call with us here to discuss how we can help.

Until next week!

All the best,