Should Startup Founders choose to Raise Funding for Equity or Convertible Note?
The Pros and Cons of Both
Most founders start out by raising money using a convertible note (Note: SAFE is also more commonplace, as compared to convertible notes in more mature economies — see my other Medium post on that later). A convertible note is simply an unsecured loan that comes with a predetermined interest rate. The interest rate is typically based on the company’s credit worthiness, and will typically be higher than a normal bank loan, but lower than equity.
If the company succeeds and its value increases, the convertible note can be converted into equity at a predetermined price (typically referred to as the “cap”) that is usually higher than what was paid for it.
If the company doesn’t succeed or if its value decreases, then the converted note holder has to accept repayment at the original amount of capital they invested.
Convertible notes are generally used when entrepreneurs don’t have many assets to offer as collateral (e.g., no house, no car), but still need capital to finance their business.
They are also generally used by investors who do not have any plans of staying involved beyond one or two rounds of financing and are thus unwilling to risk their entire investment in one round with no protection in case something goes wrong with the startup or its management team.
There is nothing inherently wrong with using a convertible note for fundraising except for two things: the interest rate may be too high for most early-stage companies, and there is often nothing in place to protect investors if things go wrong with the startup or its management team (e.g., founder gets fired).
Although there are several variations on how convertible notes can be used (e.g., flat fee instead of cap), they all share these two characteristics which tend to make them unattractive to investors given their limited upside potential and lack of protection in case something goes wrong with the startup or its management team.
Equity financing has no interest rate associated with it since investors are paying for an ownership stake instead of simply loaning money for interest payments; however, it does come with risks that should thus be compensated accordingly via an equity stake that gives investors voting rights on key matters such as who runs the company and how future rounds get priced etc..
In exchange for accepting higher risk, investors are also likely to demand a higher equity stake in the company than what they would get with a convertible note.
The challenge with equity financing is that it’s hard to come up with a fair price for the equity when you are first starting out because there is no precedent.
It’s not like you can go to the market and find out what Google, Facebook or Dropbox were valued at when they started out because they were all unique situations, and then just use that as a baseline for pricing your own startup.
The only fair price would be based on whatever valuation the market will ascribe to your company once it reaches product-market fit (i.e., can prove it has significant demand for its product/service) and is ready to scale (i.e., invest in sales & marketing) in order to fulfill that demand.
Thus, founders who choose to raise capital using equity financing rather than convertible notes have two choices:
- Sell their company at an extremely low valuation based on whatever precedent the market currently has for early stage companies; or
- Raise enough money from a small number of highly qualified investors who believe in their vision and are willing to take a large enough risk (e.g., 50%+ equity stake) that they will feel comfortable if things go wrong with the startup or its management team and still get compensated fairly if things go right.
Given these two options, most founders prefer raising money using convertible notes for two reasons:
- Most potential investors prefer them because of their limited downside exposure without any recourse; s
- Most founders prefer them because of lower friction associated with fundraising.
It’s not that equity financing is impossible; it’s just that most of the people you would want to invest in your startup are not willing to take the same risks as they would with a convertible note.
As a result, founders who choose to raise money using convertible notes end up accepting higher interest rates and no protection for investors.
In theory, this may make sense because founders are simply taking advantage of investors who don’t want to take the same risks they do, but in practice it often leads to unnecessary friction and disappointment down the road when founders are forced to start from scratch with new investors because the earlier ones backed out due to a variety of reasons (e.g., poor company performance, founder changing their mind and/or behavior, investors no longer liking the idea) that could have been avoided if both parties had invested together at an appropriate valuation from the beginning.
In conclusion, the ideal way to raise capital is to do so based on a valuation that the market will ascribe to your company once it reaches product-market fit and is ready to scale.
In practice, however, this is easier said than done because doing so requires you to get outside input from investors who can provide such insight (e.g., angels, VCs, etc.).
Furthermore, it requires you to put together a team that can help you reach product-market fit and scale your business within a reasonable time frame so that you won’t be caught off guard if investors decide not to invest at a particular valuation or if they want a larger percentage of equity in exchange for further investment.
About the Author
I am the Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students teach and learn better. I am also a mentor and angel investor in other Startups of my other interests (Proptech, Fintech, HRtech, Ride-hailing, C2C marketplaces and SaaS). You can also find me on Cudy for early-stage Startup Founder mentorship and advice.
You can connect with me on Linkedin (https://www.linkedin.com/in/alexanderlhk) and let me know that you are a reader of my Medium posts in your invitation message.