The most common way for a company to raise funding is by using debt or raising equity. A third method, which is a hybrid of these two, is from issuance of convertible notes.
Convertible notes are a type of financing that allows a company to raise money from investors in the form of a loan that can be converted into equity at a later date, typically when the company raises additional funding, or reaches a specific milestone.

In this brief article we discuss some of the pros and cons for companies using this form of financing:

Pros

Using convertible notes to raise funds is attractive to companies for the following reasons:

1. Less dilutive: This type of growth capital can be beneficial for early-stage companies because it allows them to raise money without giving up as much equity in their company. Raising funds from a convertible note, as opposed to equity, can allow the company to delay placing a value on itself by making the conversion price a discount to a subsequent round; or, the company may be able to negotiate a premium conversion price relative to the prevailing equity valuation because the noteholder gains ancillary benefits (1) a higher rank in the capital structure and (2) interest.

Subsequent round conversion pricing is especially attractive to early-stage companies that have not had time to show much traction in terms of their product and/or revenue. The premium method is useful to more mature companies, which believe at the time they cannot achieve fair value due to a low prevailing share price/valuation.

2. Cheaper than other debt: As the investor is receiving the benefit of equity upside as well as a coupon, the level of interest paid on convertible debt can often be less expensive than other types of straight debt financing.

3. No market risk: Often the only alternative to a convertible note, for a smaller company seeking grow capital, is an equity raise. This may be because traditional bank lenders perceive the company as too risky. One of the major drawbacks of an equity raising is market risk from a significant negative move in the stock market over the period when the equity raise is being undertaken.

4. One counterparty: In contrast to an equity raise, the benefit of using a convertible note for growth capital is the ability to deal with just one qualified and large counterparty as opposed to many shareholders.

Cons

On the downside, convertible notes can be less attractive for the following reasons:

1. Still dilutive: While often less dilutive than an equity raising, convertible notes still add some form of dilution, in contrast to growth capital using straight debt. Companies should be particularly careful using instruments where the minimum conversion price is not known. The lower the conversion price the larger the future dilution.

2. Repayment risk: Many convertibles include provisions for automatic conversion at maturity (converting notes), but the majority do not (convertible notes). Given that we are primarily discussing early-stage companies, most of these organisations are cash-burning at the time of the funding, and unless the new capital helps them reach profitability, or a milestone which allows them to raise more money at a premium, the borrower may struggle to repay the loan. This can result in one of four outcomes: (1) the loan provider agrees new terms, typically negotiating an additional mark-good benefit; (2) the company raises funding from a replacement note or loan; (3) the company is forced to raise equity capital which will be dilutive; (4) the company goes insolvent.

3. Price Anchor: Often convertible notes issued in growth funding situations contain a valuation cap and an automatic conversion price. Despite the fact that the borrower is technically delaying the valuation of the company, the cap and conversion price often serves as an effective anchor for the price negotiations of the subsequent funding round. Even if investors are willing to pay a substantial increase above the note valuation cap, strange situations can arise. For instance, the new investors may attempt to compel the note holders to make unfavourable changes to their terms in order to close the deal.

Parting Thoughts

When it comes to using convertibles as a growth capital it is important for companies to fully comprehend the ramifications of all potential outcomes. Companies need to consider the benefit in context of the risks if things don’t work out as planned.

As a rule of thumb look for alignment. If the convertible note provider is looking for upside from the success of the equity this is a good sign. If the lender can make a return from the conversion irrespective of the share price, the equity component is just a fee, and the borrower should be more cautious.

Find out more about PURE’s convertible debt structures can work for your company at PURE Asset Management.