When it comes to start-up funding, seed financing is the most famous avenue to raise investments for the founders. In recent years, though, convertible debts have become a favored choice due to several reasons. They bridge the gaps to find early investments, create the product, and get running.
Unlike priced equity rounds, there are no unending hours to work out the details or hefty legal costs for negotiating or drafting the equity structures. However, there are some basic terms in convertible debts that you need to understand for receiving quick financing with minimum risks. Here are a few convertible debt terms defined for you.
Understanding the Maturity Date
You can comprehend the maturity date as a deadline for a preferred round during which the convertible note can be changed into equity. It is determined at the time of creating the note and is applicable for two years after signing it. If the debt does not convert automatically after the maturity date, investors can demand their money.
Similarly, if the conversion notes accrue interest, it provides incentives for investors to wait because equity will be more significant once the founders can find a financing route.
Understanding the Qualifying Financing Round
When a company issues shares in return for investor’s money, it creates a qualifying round. A qualifying round should have a predefined size to become a conversion event.
For example, the company may set a minimum of $100,000 as a total investment for the event. It is a predefined amount negotiated when creating the debt instrument and sets the limit of the amount within the next equity financing event.
If the money received is more than the qualified financing event, your debts will convert into equity. It also offers protection to the investors against the rounds where the company can’t raise hefty capital and restricts the investors from collecting the interests.
On the other hand, the company and founders can earn significant capital in the equity round without any complications of additional share issues.
Understanding the Valuation Cap
The valuation cap is one of the critical convertible debt terms defined by the experts. It offers protection to the investors against dilution in the start-ups having high-growth funding rounds.
When you have a valuation or conversion cap, you can put limitations on the company value so that the note conversion wouldn’t happen at more than the agreed limit. It sets a threshold for convertible notes where investors may bag a substantial stake in the company.
For example, after a million-dollar investment, if a start-up gets valued at $100 million, the investors will get nearly ~1% in the company. If it has a $10 million valuation cap on the convertible note, the investors will get about 10% of stake in the company.
Understanding the Conversion Discount Rate
The convertible debts may also have a discount rate mentioned in the terms. This rate is beneficial for the investors as it values the shares at a lower price when converting the notes into stocks.
For example, an investor purchases a note of $500,000 with a 20% discount, and the company issues shares at $10/share during a round. In this scenario, the investor has to pay only $8 for each share to receive nearly 62,500 shares, instead of 50,000 shares you would’ve bought through participating in the round.
These are some important convertible debt terms defined for investors putting their money in a start-up with a promising future.