Whilst the benefits of a convertible structure for startups are apparent, namely deferring the need to set a valuation and quicker execution of the deal, the benefits for investors are slightly less obvious.
Some background on the difference between convertible notes and convertible equity
A convertible note is simply debt that can be converted into equity. The conversion is typically alongside a future funding round where the investment plus any accumulated interest is converted into equity. The conversion is based on a set discount rate and valuation cap. If there is no trigger, such as a future funding round to convert the debt, then it will usually either convert at an agreed floor price or the debt will need to be repaid.
Seedrs convertible equity differs from a typical convertible note in two key aspects to allow for SEIS or EIS eligibility: (1) there is no interest payable and (2) it cannot be repaid, therefore must convert to equity by the agreed longstop date.
Why do companies use convertible equity?
The most common reason for a company to use a convertible structure is to postpone setting a valuation until the next funding round where a recent valuation may impact negotiations. Since one of the main benefits for investors is that they receive a discount on the price set by the future funding round, it’s important that the business is in a position where this is likely to take place within the next 6-12 months.
Case study: SellMyLivestock
SellMyLivestock is an agritech company that operates a grain and livestock marketplace for UK farmers. Their first fundraise was an equity campaign on Republic Europe that closed in November 2015. Following strong growth across key metrics they decided to return to Republic Europe in late 2016 for a convertible equity campaign.
When asked why he chose this route, managing director Jamie McInnes explains, “the business was growing very rapidly and we needed some extra investment to fund the opportunities that were coming our way, and the convertible round just felt right in the circumstances because we wanted to reward investors for having faith in us.”
Their growth continued into 2017 and in the past few weeks they secured a follow on funding round of £500,000 at a £5 million pre-money valuation which triggered the conversion of the Republic Europe convertible equity investment into shares. The discount rate was set at 20%, however due to the significant growth of the business the valuation of the trigger funding round exceeded the valuation cap.
As a result investors in the convertible were issued shares at a price discounted by 39% on conversion, or an equivalent pre-money valuation of £2.8 million, representing a near doubling in paper value within less than a year.
Key considerations for investors
- Investors can benefit from SEIS and EIS relief for eligible companies raising convertible equity on Republic Europe, however only once the conversion has taken place.
- The discount rate and valuation cap both act as mechanisms to reward investors for the earlier exposure to risk compared with investors in the next funding round.
- The discount rate means that investors can expect a minimum uplift in value of their shares on conversion by at least that rate. e.g. 20% discount means a 1.25x increase in number of shares received compared to the new investors in the next round.
- The valuation cap sets a maximum value on the company at the time of conversion, or in other words the upper limit for the price investors in the convertible. If the actual valuation exceeds this, as with SellMyLivestock, then the effective discount goes up.
- Postponing the pricing for up to a year until a larger, often institution-backed, funding round means that key metrics can be more developed and the valuation is less reliant on assumptions.
Investments made into companies raising funds through convertible equity are subject to risks similar to those faced when investing into a priced equity funding round. Subsequently, investments should always be made as part of a diversified and balanced portfolio.