07 April 2021

QE: Convertible notes

Convertible note
Author/Compiled by
Cora Craigmile (cewas)

Executive Summary

A convertible note is an innovative financing instrument in the form of a loan, which the investor can later convert into company shares. Early-stage enterprises can use convertible notes to raise capital when they want to delay company valuation or when they need a faster way to access capital. Thanks to being relatively simple, convertible notes tend to need less negotiation time, and capital can move from investor to recipient at a much faster rate, as opposed to other more complex financing instruments. Investors use convertible notes when they see that a young enterprise has a lot of potential and their investment could act as a catalyst for the company to achieve its goals, knowing that at the next priced round they would get a slice of the cake by receiving shares. The terms of a convertible loan vary depending on what has been agreed on between an enterprise and an investor, but to compensate for the high risk accepted early on, the investor receives an interest rate together with a discount on company equity after its valuation round.  

Convertible notes are a good option if your company is in its early stages and you need capital for growing your business but don’t want get it through selling company shares, since at this early stage you want to retain as much ownership and control as possible over your company’s trajectory. Convertible notes are essentially debt and therefore don’t require you to have a company valuation (assessing what your company is worth) as opposed to selling equity. This makes the whole process a lot quicker and cheaper and gives your company a chance to grow in worth before a valuation is needed, which in turn will allow you to sell future equity shares at a higher price. Convertible notes are also a good substitute if you don’t qualify for bank loans due to not having collaterals (the company assets used as a security for a lender in the event that you can’t repay the loan).  

Despite being in its early growth stage however, to be a good candidate for this instrument you need to be fully confident about your company’s future success. This means having a solid business model and a good market fit which has been tested and re-tested. You need proof that with the right funding, your company will take off and reach its milestones, not just to get your investor on board but also to protect you from finding yourself in serious debt that you can’t repay. Remember that because of the high risk, the investor usually expects interest payments. At the end of the fixed term, they can choose to either receive the principal plus accrued interest or convert the loan into equity. In case of conversion, the investor will become a shareholder and will not get the investment back until they decide to sell the shares.  

The following (non-comprehensive) characteristics and implications provide you with an overview to analyse the pros and cons for this investment instruments:

 

Enterprise Lifecycle 

Early-stage enterprise with no or limited assets  

Amount 

Variable (although tends to be discrete)  

Pay-back period (Maturity) 

Varies depending on the agreement between both parties, but typically ranges from 1 to 3 years. Maturity period could be extended, if goals have not been met but the investor believes there is still potential for growth. 

Use of funds 

Mostly unrestricted, however, if the investment is impact-driven, specific terms might be drawn up to incentivise the company to certain impact milestones.   

Source: Based on (Roots of Impact, 2020) 

The following table summarises some key characteristics of Convertible Notes and implications you should consider:

Characteristics 

What does this mean for your enterprise 

No company valuation is required. 

The main benefit of the convertible note – which acts as debt – is that both the enterprise and the investor can avoid lengthy negotiations regarding company valuation (assessment of your company’s worth) at the beginning. This will not only reduce the time needed for getting the financing, but it will also delay your valuation until you are in a stronger position to.   

Flexible and simple set-up period. 

Due to its inherent simplicity, convertible notes require less negotiation time, less legal and administrative fees and founders typically receive the investment within 2-6 weeks (as opposed to equity, which can take much longer to set up).  

Company equity substitutes assets as collateral. 

Since a young enterprise usually doesn’t have enough assets to act as collateral, the company equity acts as collateral for the convertible note investors.  

Valuation cap, understood as a defined valuation amount at which a convertible note can be converted into equity  

In order to compensate your convertible note investor for having taken on the risk of investing early, you have what we call a valuation cap, which determines the conversion price. This means that the convertible note holder can either calculate the share percentage from the valuation cap amount or the actual valuation amount of the financing round. It prevents the misalignment between the investor and entrepreneur, since without it, the investor would not want a higher valuation. 

Discount rate for the investor is applied to equity.  

Upon maturity, or when triggered, a convertible note allows the investor to convert the principal and the interest into shares, for which they receive a discount. This means that in the subsequent priced round the investor will get shares in your company at a discounted rate, as supposed to new investors who will have to pay the full amount, in accordance with the outcome of your company valuation. 

Convertible notes come with an interest rate relevant to the amount of money lent. 

The convertible note is a hybrid debt instrument, and as such it has an interest rate. Unlike a traditional loan, however, the interest is typically not paid until the pre-agreed maturity date (date when loan has to be paid back). Furthermore, in the majority of cases the interest converts into equity instead of being paid out in cash (Roots of Impact, 2020).  

While the debt is outstanding, investors usually have little say in company trajectory since they don’t tend to get voting rights.  

This is one of the things that drives young enterprises to consider convertible notes as a funding instrument. By delaying the dilution of company ownership, you as the founder can have more control over your company trajectory while it is still in its premature stage (at least before the convertible note reaches its maturity and is converted into equity) 

Key features

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  • Convertible notes are an attractive financing option for young enterprises that need to raise capital but want to delay establishing a company valuation and therefore can’t raise capital through a priced round. They offer flexibility, simplicity and a faster negotiation period, making it cheaper and easier to access than other types of financing and acting as a buffer to allow the company more time to grow and be in a better position to establish a good valuation. They are therefore suitable for young companies that may not yet have enough customer traction but are expected to grow and get good traction in the long run.  

  • Convertible notes tend to have a few triggering events, understood as the moment in which the note can be converted into equity or cash. These triggering events will be pre-defined by both parties in the terms and conditions. Usually, they include reaching the valuation cap in the subsequent funding round or if the company is being bought. It is crucial that you as the founder are absolutely clear on what these triggering events are and have an idea of when and how they could take place, ensuring that they are clearly described in the terms and conditions to avoid potential misunderstandings. 

  • Although traditionally convertible notes have been adopted by companies in their early stages, the instrument is increasingly being used by established companies who can also benefit from this hybrid financing tool – namely, through its ability to avoid a „down round“(LOIZOS,C., 2020).  

Tips to build your investment case as an early-stage water-related enterprise

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Basic requirements 

Although there are no fixed rules for qualifying for a convertible note, since the instrument offers both investors and recipients a lot of flexibility, there are a few non-negotiables that your company should establish before considering this form of financing.  

  • First and foremost, you must have a high growth potential. This includes either already having or expecting to gain significant customer traction and having very clear milestones.  

  • Further, you are planning to have a future funding round (at which point the loan would be converted).  

  • Lastly, you must be prepared to offer these early investors certain perks for taking on the risk and believing in your company. As already mentioned in the table above, these may include conversion discount and valuation cap.  

Like any other investor, with a convertible note, your investor will want to make sure that their investments will generate a financial return in the future. Although convertible notes are a relatively cheap and easy financing option for early-stage enterprises, you need to prepare a good pitch to convince an investor of the great benefits and potential for financial return. 

Convertible notes in the water, sanitation, hygiene and waste management sectors 

Start-ups with high growth potential, particularly in the tech sector, have up until now highly benefited from convertible notes. Because of their rapid growth potential, tech start-ups have been in an ideal position to convince investors that investing in quasi- “possible future equity” will be worth their while. Although not every sector will be able to benefit equally from this tool, high-potential young enterprises in the WASH and waste management sector with a tech component could learn from tech start-ups case studies that have benefitted from convertible notes.  

If you’re not tech oriented, build an investment case and leverage the potential of water-related markets...

Commercial funds and investors aim to convert convertible notes into equity that they can sell later on for a higher price. When approaching investors, you should have a strong investment case at hand. For this purpose, you should have a clear line of argumentation at hand that underpins the market potential of your business model. Keep in mind that globally the water sector is one of the biggest investment markets. Many enterprises have already become profitable. With a thorough competitor analysis, you can collect references from similar businesses in other markets that support your prospects for success. To showcase your potential to succeed in a promising market, you can, for instance, combine strong market arguments you derive from the competitor analysis with the operational and strategic differentiators that make you stick and the evidences you already build that point towards success.  

Leverage your impact profile to access convertible notes from impact investors 

What if your company has less potential for direct financial returns but huge potential for generating a positive social or environmental impact? Investors that are not only driven by financial outcomes but also by positive social and environmental outcomes (what is often referred to as “impact investors”) might accept a lower financial return on investment if that is supplemented with a substantial social or environmental impact return. Here are a few strategies you can deploy to leverage on impact when pitching your company to potential investors:  

  1. Know your SDGs and understand how your company is contributing to their achievement: As the global blueprint for sustainability and peace, the 17 SDGs are used by most impact-driven institutions as a reference point for managing, measuring and monitoring impact. This is especially the case with Development Finance Institutions (DFIs), financial entities that want to ensure that their investment not only generates a financial return but also actively contributes to the achievement of the SDGs. As an SME working in the water, sanitation, hygiene or waste management sector, your contribution to global development goals can be used to motivate investors with the right agenda to invest in your product/service.  

  1. Traditional investors will focus on the risk-return trade-off when making an investment decision (UBA et al., 2020). However, as already mentioned a new type of investor has been emerging that is also considering a third dimension – impact. An interesting variant of a convertible note could offer financial rewards for reaching impact milestones. An example of such a financial reward could be the reduction of the equity discount rate offered to investors or increase in the valuation cap. If you are approaching an investor that could potentially consider these “rewards”, make sure you put on your negotiating hat and be prepared to have answers for any questions regarding the impact that your company is (or will) generate and a clear roadmap of how it will be achieved. If the investor senses uncertainty and is not convinced that your company will reach impact milestones it is likely to be put off, especially if the financial returns are not high.  

Since the convertible note is a very flexible tool, its terms can be adapted to your specific case to accommodate the needs and objectives of both parties. Having a strong pitch ready and legal support by your side will be essential for securing a mutually beneficial and transparent deal.   

Negotiating better conditions for convertible notes 

Ok, so you’ve decided that a convertible note is the right financing instrument for you but how are you going to attract investors and convince them to buy them? One of the most important things for securing a good deal is trust, if the investor doesn’t fully trust you, they will either step away or make the terms and conditions less favourable for you. To convince your potential investor that they can trust you and that the convertible note will be put to good use, with no “nasty surprises”, there are a few things you should consider in the convertible notes agreement that will make the investment more attractive for investors:  

  1. A valuation cap will give your investor some peace of mind in the eventuality that your company’s valuation in the next priced round is a lot higher than expected. 

  1. Prepare for any and every scenario. Questions such as “what happens if the company decides not to do a future priced round and where does this leave the investor?” or “what happens if the convertible note reaches its maturity before the priced round?” should be thoroughly discussed. This will put both you and your investor at ease.  

  1. Your convertible note investors should not get less favourable conditions than new investors in the following pricing round. They are the ones who had faith in you after all. So how are you going to compensate them? 

  1. In order to avoid bad outcomes for either of the parties, ensure that interests are aligned in the terms and conditions and that both you and the investor are absolutely clear on what you are agreeing to. Make sure you understand all the terminologies and what it means for your company. For example, what does the valuation mean for your company and how will it affect both you and the investor? 

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