Over the past few years, we have seen an increase in announcements of cannabis companies raising capital. Venture capital funds are slowly opening their doors, seed funds, super angels, angel groups, incubators, and “friends and family” are all starting to play the seed financing game and have begun investing early in cannabis startups. Lately, I‘ve been getting more and more questions about convertible note: “What is it?” and “Should I use it?”
At DCN, and currently going through our journey of fundraising, I figured now’s the right time to answer a few questions and help fill in the blanks. Please note, I am not a lawyer, and this is more for educational use, so you have a better understanding and can use this to start asking the right questions between you, your team, investors and your legal team.
In short, a convertible note is a form of financing. This financing gives investors the right to preferred stock within your company once a triggering event occurs.
So what’s that mean? First some of the basics
A convertible note is essentially a debt/equity hybrid structure which, if well structured, is a flexible, cost-effective and straightforward way to raise a seed round. Convertible notes are used in more than 2/3 of all financings.
The valuation cap is the maximum valuation at which the note can convert to equity.
The interest rate is the annual rate at which the interest on the loan accrues.
The conversion discount is a discount that will be applied to the convertible note when it converts to equity.
Term Length is the maturity date or length of time (usually in months) by which the company has to either repay the loan or reach their milestone event.
Now that we have gone over a few key terms in a convertible note let’s go over the Pros and Cons.
The Pro’s, and Cons
Typically less involved and less paperwork than equity rounds; can cut down on time and legal fees.
Investors enjoy downside protection as debtholders during the earliest stages of the company when the company is at critical growth stages.
The company can defer the negotiations surrounding valuation until later in the company’s lifecycle (i.e., for very early stage companies at the earliest stages of planning and preparation, valuations can be more difficult to define)
At conversion, note holders typically receive discounts or valuation caps on converting balance, thereby rewarding the earliest investors appropriately for their early investment in the company but without causing valuation issues for the company
If a convertible note is made to be too large, it can negatively impact your next round because it’ll convert to a disproportionally large portion of your next round, effectively crowding-out your next round’s potential investors from having the equity stake they may desire.
If a convertible note’s cap is made too low, to accommodate a more substantial round later, the Founders may need to take the additional dilution that would happen if they exceeded the convertible’s cap.
Because a convertible note can be made to be quite versatile, sometimes investors can add clauses in there that have more significant implications down the road, such as being able to take up more of a future round than the actual amount they’ve put in, for example.
If not careful, you can accumulate various too much convertible debt which may burden you at a conversion point
Notes give convertible note holders the investor rights of future investors (say in a future Series A Preferred Shares), which may include more rights than those they would take for the amount of money they put in had they merely done an equity deal on Ordinary Shares with you today.
If the convertible note automatically converts at the next equity raise (i.e., the investor has no choice), investors may wind up being forced to convert into securities shares despite not being happy with the terms of the equity financing. The note holders may, unfortunately, have less influence in negotiating the terms of the equity financing, which partially explains why some investors are reluctant to invest with convertible notes.
Finally, while convertible notes allow the company to defer the valuation conversation until a later time (see discussion under “Pros” above), any inclusion of a conversion cap will raise a similar conversation, which defeats some of the purpose for why companies and investors alike favoured initially the convertible note as a quick-and-easy financing solution, to begin with.
How Do Convertible Notes Affect Dilution?
Any time a company takes on new money, they give out equity which dilutes the current shareholders. Convertible notes are no different. They are investments that convert at a later time into equity, and depending on the severity of the terms set in the note, the amount of dilution will be subsequently affected.
This is when you need to be careful and make sure you understand the terms completely; otherwise, you could put your company and shareholders at risk.
Tips for Entrepreneurs
1. Terminology: Sometimes convertible note gets referenced as convertible debt. It is also called bridge financing because it bridges the company over until it can get a specific type of financing. Don’t get confused about this.
2. Convertible Equity: Consider convertible equity instead of convertible debt. I’ve seen investors not want to go for it, but if you can get it then do it.
Convertible equity doesn’t have the repayment feature at maturity. Instead, at maturity it will convert into equity at some pre-negotiated price or the maturity date will be pushed into the future. It removes the massive threat of the investor being able to drive the company into bankruptcy.
3. Discount range: The discount should be about 10-30% off of the qualified financing price per share. Don’t allow the convertible debt holder to get both discounts and warrants. Warrants are options to purchase shares at a specified price in the future. Convertible debt holders should either get a discount or warrants. A discount is preferable because it is simpler.
4. Qualified financing size: The qualified financing that triggers a conversion needs to be big enough such that various rights are properly negotiated. But not so big that it never triggers the conversion.
5. Interest rate: Interest rate should be low
6. Valuation caps: Watch out for valuation caps.
Valuation caps are the difference between a great deal for entrepreneurs and a terrible deal. A deal without valuation caps can be great for entrepreneurs. With valuation caps, it can be a nightmare, so take caution. I stress for reasonableness. Also, this is an area where it’s important to be reasonable.
Convertible notes can be very friendly to early-stage companies and founders, but heed my word of warning – know the terms. If used correctly, convertible notes will be beneficial for founders and investors, but if handled poorly, they can be costly for founders.
So how can you make smart choices with your equity? It comes down to resources. You want to speak with your legal team, mentors, and advisors and do your research. You need to have an understanding of how this all works so that you and your business partners can make a confident decision on if convertible notes are best for the founders, the team, and the potential investors.
Disclaimer: The terms highlighted herein do not reflect a complete description of the use or definition of the terms. These terms reflect a general use and understanding to the best of our knowledge. Any entrepreneur and investor are encouraged to seek further information as we are not offering any legal, financial or accounting advice.
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