What's Below in Issue #46:
📰 - An overview of convertible venture debt
📊 - Data behind VCs wanting exits
🎙️- Podcast about a $3M Seed Round
🆓- Free startup resources
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Convertible Venture Debt: A Smart Way to Raise Funding for Your Startup
If you are a founder of a startup, you may have heard of convertible venture debt as a way to raise seed funding for your business. But what is it exactly, and why is it useful? In this article, we will explain the basics of convertible venture debt, its advantages and disadvantages, and when you should consider using it.
What is convertible venture debt?
Convertible venture debt is a type of financing that combines the features of debt and equity. It is a loan that you take from an investor, usually an angel or a venture capitalist, to convert it into equity (shares) in your company at a later stage. The conversion happens when a specific event occurs, such as a future round of funding, an acquisition, or an IPO.
The terms of the loan are usually specified in a document called a convertible note, which contains the following elements:
- The principal amount: This is the amount of money that you borrow from the investor.
- The interest rate: This is the annual percentage rate that accrues on the principal amount until the conversion or repayment.
- The maturity date: This is the date by which you have to either repay the loan or convert it into equity.
- The conversion discount: This is the percentage discount that the investor gets when converting the loan into equity. For example, if the conversion discount is 20%, the investor can buy shares at 80% of the price paid by other investors in the future round.
- The valuation cap: This is the maximum valuation of your company at which the investor can convert the loan into equity. For example, if the valuation cap is $10 million, and your company raises a future round at $15 million, the investor can still convert the loan at $10 million, getting more shares for their money.
Why is convertible venture debt useful?
Convertible venture debt has several advantages for both founders and investors. The main advantage of convertible debt is that there is often no payback period. Unlike other forms of debt that require paying back the loan, convertible debt is often changed to equity, and the payment plan is never enforced. This is incredibly helpful for startups with little to no cash flow to pay back interest and principal payments. This comes with the equally large risk that the debt is not converted (for a variety of reasons) and the startup is forced to pay back the debt.
Other advantages of debt are:
- It is faster and cheaper than equity financing: Raising equity financing requires a lot of time and effort to negotiate the valuation and terms of the deal. With convertible venture debt, you can skip this process and get money quickly and easily. You also save on legal fees and dilution costs.
- It defers the valuation issue: Valuing a startup is very difficult, especially in the early stages when there is little or no revenue or traction. With convertible venture debt, you can postpone this problem until your company has more data and traction to justify a higher valuation. This way, you avoid giving away too much equity at a low valuation.
- It aligns the interests of founders and investors: With convertible venture debt, both parties have an incentive to increase the value of the company. The founders want to raise a future round at a high valuation to minimize dilution, and the investors want to do the same to maximize their return on investment. This creates a win-win situation for both sides.
When should you use convertible venture debt?
Convertible venture debt is not suitable for every startup or every situation. Here are some scenarios where you should consider using it:
- You need a small amount of money to bridge a gap: If you need some extra cash to reach a milestone, such as launching a product, acquiring customers, or generating revenue, convertible venture debt can be a quick and easy way to get it. You can then use your progress to raise a larger round of equity financing later.
- You have strong traction but no clear valuation: If you have proven your product-market fit and have impressive growth metrics, but you are not sure how to value your company, convertible venture debt can help you avoid underpricing or overpricing your equity. You can let the market decide your valuation in the future round while giving your early investors a fair reward for their risk.
- You have high-profile investors who can add value: If you have access to investors who can provide more than just money, such as connections, advice, or credibility, convertible venture debt can be a way to attract them without giving up too much control or ownership. You can leverage their network and expertise to grow your business faster and raise more money later.
How does the math behind convertible venture debt work?
To illustrate how convertible venture debt works in practice, let’s look at an example:
Suppose you are raising $500,000 in seed funding for your startup. You have two options:
- Option A is to sell 20% of your company for $500,000 in equity financing
- Option B is to take $500,000 in convertible venture debt with an interest rate of 8%, a maturity date of 2 years, a conversion discount of 20%, and a valuation cap of $4 million.
Let’s assume that after 2 years, your company raises a Series A round of $2 million at a pre-money valuation of $8 million. How much equity will you have to give up in each option?
In Option A, you will have to sell 20% of your company for $2 million, which means your post-money valuation will be $10 million. Your equity stake will be diluted from 80% to 64%, and your early investors will own 20% of your company.
In Option B, you will have two scenarios depending on whether the conversion discount or the valuation cap applies. The conversion discount applies if the valuation cap is higher than the pre-money valuation of the Series A round; the valuation cap applies if the valuation cap is lower than or equal to the pre-money valuation of the Series A round. In this case, the valuation cap ($4 million) is lower than the pre-money valuation ($8 million), so the valuation cap applies. This means that your early investors can convert their loan into equity at a valuation of $4 million, instead of $8 million. The amount of equity they get is calculated as follows:
- First, we add the interest accrued on the loan to the principal amount. Assuming annual compounding, this is $500,000 * (1 + 0.08)^2 = $583,200.
- Second, we divide this amount by the valuation cap to get the percentage of equity they get. This is $583,200 / $4,000,000 = 14.58%.
- Third, we subtract this percentage from 100% to get the percentage of equity you keep. This is 100% - 14.58% = 85.42%.
Now, you will have to sell 20% of your company for $2 million, which means your post-money valuation will be $10 million. Your equity stake will be diluted from 85.42% to 68.34%, and your early investors will own 14.58% of your company.
As you can see, in Option B, you end up giving up less equity than in Option A, because you deferred the valuation issue and gave your early investors a lower price than the Series A investors.
Of course, this example is simplified and does not take into account other factors that may affect the outcome, such as dilution from employee stock options, liquidation preferences, or multiple rounds of funding. However, it illustrates the basic logic and math behind convertible venture debt.
Convertible venture debt is a smart way to raise seed funding for your startup if you want to avoid the hassle and uncertainty of valuing your company in the early stages. It can help you get money faster and cheaper than equity financing, defer the valuation issue until you have more data and traction, and align the interests of founders and investors. However, it also comes with some risks and trade-offs, such as paying interest, having a maturity date, and giving up some control and ownership. Therefore, you should carefully weigh the pros and cons of convertible venture debt before deciding whether to use it or not.
Relevant Articles to Raising from Venture Debt
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Venture Capital Funding: Essential Things to Know About Venture Debt - 👉 The Motley Fool
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Understanding Venture Debt Financing - 👉 SVB
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Venture Debt: Benefits & How To Pick A Lender - 👉 Saratoga
Data Corner
VCs Want an Exit
In the past 10 years, there have been over 1,000 companies that have crossed the magical Unicorn $1B valuation, but only 200 have IPO'd. This creates a problem for the VCs that have put money into these startups and need a large liquidity event to create returns.
The problem is many of these startups were valued with inflated multiples and that it is unlikely that all will be able to IPO for over the $1B threshold. VCs will not want a "down-round" liquidity event which will show investors they overvalued their investments. This tension will also have VCs thinking more carefully about how they value a startup before deploying capital.
Fundraising Demystified Episode #21 is Live!
This week on the #FundraisingDemystified podcast, we have the pleasure of welcoming Jack Hamrick, the founder and CEO of Foraged. Jack takes us through his journey of creating Foraged, a marketplace for wild and specialty foods. It all started when he was on the hunt for a specific mushroom and realized the lack of availability in the market. This led him to the idea of creating a platform that connects consumers with rare and specialty foods. Jack emphasizes the importance of finding investors who understand and embrace the disruptive nature of Foraged in the traditional food marketplace. He also highlights the recent success of Foraged, including their seed round where they raised an impressive $3 million in capital. Join us as we delve into Jack's unique fundraising experience and explore the exciting future of Foraged.
Here are 3 key takeaways from this episode that you won't want to miss:
- Know Your Market: Understanding your target market and customers is crucial when raising capital. Investors want to see that you have a deep knowledge of your niche and how you differentiate yourself from existing categories. Stay true to your mission and showcase your expertise in your market.
- Timing Is Everything: When announcing your funding, consider the impact it may have on your business and the community you serve. The strategic timing of your announcement can play a significant role in attracting talent and building legitimacy. Use it as a tool for PR and marketing, but always prioritize the best interest of your business.
- Embrace the Honeymoon Phase: Receiving interest from venture capitalists is an exciting and rare occurrence. Enjoy the attention and value the thoughtful emails from VCs. Remember, it's not just about the money, but also the advice and input you receive. Building relationships with investors who align with your vision and values is key to long-term success. Listen Here
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Written by Jason Kirby - https://www.linkedin.com/in/jasonrkirby
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