Convertible Note vs. Equity Explained | Pros & Cons Compared

Startups almost always need startup funding . That's why new small businesses often have what are called "investment rounds." During investment rounds, companies approach investors and offer shares in the company in exchange for financing. Using that money, the startup gets off the ground, develops its infrastructure, and otherwise takes care of business so it can start turning a profit in another few years. However, some company owners don't like having to sell pieces of their company in exchange for financing, at least immediately. Instead, company owners may decide to use convertible notes to raise the capital necessary to keep their business afloat. Convertible notes still result in a company's shares being sold to investors, but it delays this effect and provides some other unique advantages that may make it a good choice for your business's needs. Let's break down convertible notes versus equity and look at both funding sources' pros and cons.

What is a Convertible Note?

A convertible note is a unit of convertible debt. In a nutshell, convertible debt is a type of “bridge business loan ” to help startups and other small businesses between rounds of financing or to fund them for a short amount of time until they start turning a real profit. Convertible notes, being short-term debt instruments, eventually convert into equity. Equity (more on this below) is essentially the value of the company converted into shares (or pieces of ownership). When they are first issued, convertible notes are structured as debt investments. The notes are written with provisions that allow both the principal amount of the notes as well as accrued interest to be converted into equity investments at some predetermined later date. Put another way:

• Convertible notes indebt a company to an investor for a specified amount
• Company owners issue convertible notes instead of equity to acquire the financing they need to expand or become a larger company
• At another date, the convertible notes' combined principal and interest values are converted into equity or shares, giving the owner of the convertible notes some ownership of the original company

It's a bit technical, but it becomes easier to understand once you break down all of these terms:

• The interest of a convertible note isn't paid in cash, but instead adds up to greater shares of equity once the note matures.
• The maturity date is the date at which the convertible note becomes company equity. On this date, convertible notes are due and can be paid to investors in equity if they haven't already.
• Conversion discounts are often included with convertible notes as "deal sweeteners". Basically, investors who purchase convertible notes get a discount on the price per share for new equity. This allows them to purchase more equity in a company with the amount of their convertible note than they would if they purchased shares from outside the company.
• Conversion provisions are often included as well. These are just the terms of the convertible note that determine the date, the interest rate, and other factors.

Convertible Note Example

Still a bit confused? Not to worry. Here's a brief but effective example. Imagine that an investor purchased $25,000 in convertible notes to fund a company that he believes will succeed in the future. The convertible notes have an 8% interest rate , as well as a 20% conversion discount . 18 months after purchasing the convertible notes, the original startup holds a qualified financing session. The company begins to sell equity (the shares in the company that determine overall ownership) at a price of $3.50 per share . The notes, by this point, should have accrued $3000 in interest given the 8% interest rate . This means that the company owners owe the original convertible note investor $28,000 . Then they also must take into account the 20% discount. This makes the actual price per share $2.80 for the convertible note investor . Due to the $28,000 of convertible notes, the investor gets 10,000 shares of the company's stock . This is far superior from the investor's perspective since they would have only received over 7000 shares of stock if they had waited to purchase the stock now.

Pros of Investing

Convertible notes are, no doubt, more complicated than the standard equity-based investing explained below. But there are plenty of reasons why many startups are looking to convertible notes for their early funding rounds:

• Determining the actual value of a startup is particularly hard, especially if the startup in question can't turn an immediate profit due to the products or services it provides. Convertible notes let companies delay the valuation phase and get financing early when they are most likely to need it.
• In many cases, equity valuation can take weeks or months before the terms (such as how many shares to offer or the price of the shares) are fully settled. Again, convertible notes allow companies to get funding fast when they need to keep afloat.
• Startup owners who are interested in owning their companies more directly will also find convertible notes effective, as convertible notes allow owners to own more shares of the company for longer (at least until the convertible notes mature).

Cons of Investing

There are also plenty of reasons to avoid convertible note investing:

• It can be difficult to find investors who prefer convertible notes. Many of them prefer the traditional debt method of buying equity in a company.
• Furthermore, angel investors get huge tax breaks when they invest in equity, but do not get tax breaks for investing the same amount in convertible notes . Thus, it can be difficult to attract enough investors to your startup using the convertible note method.
• Company owners can actually lose their companies if they default on convertible notes , so the pressure to turn a profit can be higher than average.

What is Equity?

When trying to finance new expansions or to grow from a small startup to a larger business, companies also have the option to calculate and sell equity . Put in simpler terms, this just means dividing up the ownership of the company into shares and offering those shares to either private investors or on the stock market. With this funding method, a startup or company is given a pre-money valuation. This just means that qualified appraisers investigate the company and come up with an overall projected value for the company even if it hasn't started to turn a profit yet. Using this analysis, a share price is determined for the equity funding round. This allows investors to purchase shares in the company by purchasing pieces of equity. The more shares they own, the better the return on investment and the more control they have over the company in question. For example, consider a startup that has a pre-money valuation worth $1 million. For simple math, let's say that the company decides to sell 1 million shares (aside from the shares owned by the founders or top executives). This means the price for company equity is $1 per share. An investor could then make an investment of $200,000 and, accordingly, get 200,000 shares as a result. When the company eventually does make a profit and a "post-money" valuation is made, the company's actual value is found to be $1,200,000. The lucky investor now owns 16.6% of a company that will, hopefully, turn a significant profit in the future.

Pros of Investing

Many investors and company owners still prefer using equity funding methods.

• Equity is often cheaper than convertible debt . That's because convertible notes often cost up to 25% more to the startup company compared to equity deals due to discounts and the cost of issuing the notes in the first place.
• Equity deals are often better defined, both for investors and for company owners.
• It's a lot easier to find investors to finance your company if you use a traditional, equity-based debt deal as opposed to convertible notes.

Cons of Investing

As with convertible notes, there are some reasons to avoid equity-based debt deals.

• Company owners dilute their control of the compan y when they use an equity deal, as they're literally selling shares of the company in question.
• Equity deals can take a long time to hash out , which can be terrible for smaller companies that need an injection of cash fast.

Summary

Ultimately, both methods of funding can be (and often are) used to great success. It all depends on your preferences, the level of risk you're comfortable with, and whether you want to trade some ownership of your company to shareholders now or kick that decision down the road until some more major decisions have been made by you and your other company co-founders. For help getting your business funded, Seek Capital has you covered with tons of funding options to help get your idea off the ground. Check out our business funding options here , or explore our blog for more helpful info to keep you educated about all your options! Sources https://www.toptal.com/finance/startup-funding-consultants/convertible-note https://www.investopedia.com/terms/a/angelinvestor.asp https://www.investopedia.com/terms/e/equity.asp