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Cannabis startups, like all startups, cannot survive without capital. The perennial question, of course, is how this capital can be raised and at what cost. Short of having an eccentric and wealthy uncle who is willing to gift you hundreds of thousands of dollars, your startup will likely need to raise capital in one of two ways: equity or debt. Is one route better than the other? Well, it depends.

Convertible Debt Notes: Here’s How They Work

This article will briefly cover these two principle options before delving into the highly common, albeit slightly tricky debt instrument often relied upon by early startups called convertible notes.

Exchanging Capital for Equity: The Fundamentals

The basic idea behind the capital-for-equity model is that an investor buys an ownership stake in a company in exchange for capital. Yes, it really is just that simple: Equity is ownership and in order for investors to own part of a company, they must pay for it. The model naturally has advantages and disadvantages and without exploring this topic in excessive detail, there is an essential principle to this formulation that is important to understand before we can consider why debt is so often used.

Early stage companies without a proven record of success (as determined by sales, profits, and other negotiated metrics) will have a very difficult time convincing any serious investor or VC firm to give them money in exchange for equity; after all, why would an investor, or anyone for that matter, want to own a piece of a company that hasn’t yet proven itself to be a success? The risk of losing the capital investment is simply too great. This is, of course, the reason why the mere capital raise is in it of itself a great accomplishment! It is an expression of the very real belief the investors (and seemingly the market) has in the future profitability of the cannabis company and portends great things for the future.

Debt: It Doesn’t Have to be Such a Nasty Word

The ‘don’t get into debt’ mantra has been imparted to us as early and as fervently as the ‘don’t talk to strangers’ edict and for good reason; debt nearly always comes with steep interest rates. However, for the reasons outlined above, startup companies often cannot convince investors to give them money in exchange for capital and instead, are forced to borrow money and assume debt.

Typically, one can obtain a loan from one of two places; a bank or a private lender. Banks are a rather obvious and safe choice but because cannabis is still federally illegal, most national banks and indeed even smaller regional banks are reluctant to loan money to businesses involved in the cannabis industry. Savvy investors recognize the predicament this places cannabis startups in and will often demand higher interest rates than would otherwise be possible to demand of startups in “regular” industries.

Still, while no one enjoys paying interest on loans, debt is an indispensable way for cannabis startups to access desperately needed cash. Indeed, under certain circumstances, the debt may actually make more sense for a company than giving away equity and should not necessarily be viewed as a bad thing. Consider for the moment a situation where a cannabis startup developing newly designed titanium bongs has just received a massive purchase order from the largest dispensary in the country.

The order is so large that the company does not have the initial funds required to pay their manufacturer to produce the bongs. What should this company do? Well, in this case, a short-term loan actually makes quite a bit of sense. The company just needs very quick access to capital to fund the impending purchase order and because of the quick and assured turn around in sales (to the dispensary), it is likely better for the company to assume the debt instead of giving away equity to an otherwise unnecessary investor. Ultimately, a debt instrument, like any tool, can be wielded to great ends but if handled incorrectly, can cause vast financial devastation.

Understanding the Convertible Note

Now that we all have a solid understanding of the two central avenues of capital raising, we are ready to delve into the more idiosyncratic but powerful route of the convertible note. As described above, equity can be both enormously profitable for an investor but also immensely risky. If the startup is a success, the initial capital injection required to buy into the company will be but a small sacrifice for the wealth gained through an ownership interest. However, if the cannabis startup is a failure, the equity stake purchased with hard-earned cash is worth nothing and the investment will prove to be a huge waste of money.

In order to better straddle this line of risk and reward, startups and investors rely on the very mutually beneficial debt instrument called a convertible note.
A convertible note is a type of short-term debt that transforms into equity upon a certain triggering event. The central idea is as follows: An investor loans a start-up a sum of money but instead of requiring the startup to pay that money back, the two parties agree to convert the money owed into an equity interest in the company.

Why is this a good thing? Basically, convertible notes allow both the investor and the startup to suspend the initial valuation of the company’s worth otherwise required to determine a fair capital-for-equity exchange. Recall, early-stage startups typically have not experienced financial success and still need to prove the viability of their business model before seeking an investment.

Under the convertible note, investors are still giving the startup capital as an initial loan (thereby reducing their risk) while assuring the startup that upon a certain trigger (like a Series A round which indicates the growth of the company), that loan will convert into equity. Fundamentally, convertible notes are powerful because they reduce the risk of the investors while giving the startup time to prove its model and ultimately relieve itself of debt.

Essential Terms of the Convertible Note

Discount Rate: Remember, investors are taking a risk in both investing in and loaning early-stage cannabis startups capital. To compensate investors for this risk, investors are given a discounted rate on the future valuation of the company during a later financing round (in comparison to future investors).

Valuation Cap: Beyond the discount rate, the convertible note again recognizes the risk on the investor side of the deal and compensates investors by capping the price of the point at which the debt converts into equity. The idea here is that if there is no cap, or if the cap is excessively high, the debt-turned-equity could potentially account for only a very small ownership stake in the company.

Interest Rates: This is often a very hotly debated and negotiated aspect of any convertible note but as discussed above, debt is nearly universally accompanied by interest. The obvious question here is whether or not the startup still needs to pay the interest on the initial loan if the loan will ultimately convert into equity. If the company does need to pay interest, when does it need to pay it? Does the interest also convert into shares of stock?

Is a Convertible Note the Right Choice For My Startup?

The objective of this article is simply to provide the reader with a basic illustration of the various financing options available to them when raising capital for their startup. Is raising equity the best option for satisfying the startup’s financial needs? Conventional debt? Convertible notes? Hopefully, this article has made it clear that there is no “right” answer, in the objective sense of the word, but only a “right” choice for the particular startup. Taking on debt and/or giving away equity is a very big decision indeed and should not be done without extreme due diligence and care. As always, #protectyourstash.

Abe Cohn manages THC Legal Group, a Marijuana Law Firm specializing in the cannabis industry. Their attorneys assist startups, entrepreneurs and established businesses protect their most prized assets. Connect with them to learn more.

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