Convertible Notes for Online Startup Investing

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"Over the past two years, there has been an explosion of the use of convertible notes for seed rounds" states James Geshwiler of Common Angels a local firm in Boston. Convertible Debt or Convertible notes are a hybrid funding mechanism. Convertible debt, usually in the form of a convertible note, is essentially a loan which converts into equity at a later date. We observe the stated growth in online offerings utilzing our analytics solution. According to our data 31% of offerings this year have been convertible debt.

convertible note graph 2014 and 2015

 

Equity funding online, which includes convertible debt offerings and some are using the term Equity Crowdfunding, has seen rapid growth from 2012 to 2014. 

Investing in Startups and Startup Funds

Equity Investing online in startups is similar in structure to traditional private equity, Angel or VC investments, with added crowdfunding dynamics. When an entrepreneur or business sets out to attract investment and does not have a strong network of accredited investors they can turn to online funding platforms. The move of capital to online platforms have lowered costs to investors and empowered more people to help entrepreneurs. This has begun the shift in capital markets, SEC regulations, funding amounts, geographic effects and marketing possibilities. This has and will continue to improve the impact initiatives being funded via equity crowdfunding.

Platforms Offering Convertible Debt

Many equity crowdfunding platforms operate a performance-based carried interest model, either alongside transaction fees and fixed costs, or independently of them. Typically, carried interest is charged at 0-10% for platforms prioritizing deal quantity over quality, and up to 20% for models with an imperative on deal quality.

Above are Equity Crowdfunding Platforms We Cover. For more information on online equity investment view the Fund Wisdom Research Reports produced Yearly and Quarterly.

 

Convertible Debt

A convertible note is a short-term loan with maturities ranging from 12 to 36 months. Instead of paying interest in the form of cash, which would deplete valuable resources of a young company, interest accrues until maturity or conversion. A conversion of the loan (plus accrued interest) into equity is triggered by a subsequent priced equity financing round, typically known as a Series A financing.

Pros and Cons

James GeshwilerJames Geshwiler has written and spoke extensively on this topic. Below are seven surprises about convertible notes everyone should know.

  1. Little Value Add from Investors
  2. Reduced Incentives to Help
  3. Increasing Preference
  4. Loss of Angel Investing Allies
  5. Deceptive Dilution
  6. Full Ratchet - re-pricing at lower equity price
  7. Less Discipline - postpone creating board

More on this article.

Mark Suster, an entrepreneur turned VC, has written extensively about the pros and cons of convertible debt.


Ludwine Dekker, campaign manager at Symbid, had talked about her opinion about advantage of convertible debt in her article-- Convertible Loans as a Band-Aid Solution to the Valuation Problem in Equity Crowdfunding

"If you don't know exactly how equity investing works or what it might mean for your company (which unfortunately is the case more than we'd all like to admit) let alone cracking your head over a reasonable valuation, convertible loans sound pretty good. It's a loan against fairly low interest rates. And when the creditor in a later stage becomes shareholder, he often doesn't own voting rights."

Disadvantages: the first problem is that the risk reward between the seed round and the Series A investors is not reflected in the 20 percent discount. The seed round is much riskier than the next round. A second disadvantage is the nonalignment of incentives between seed-round investors and company management. The latter want the Series A round to be at as high a valuation as possible, so they dilute their ownership as little as they can. In contrast, seed investors want the next round to be as low as possible so they get the biggest percentage of the company that they can for their investment.

Pros and Cons of Straight Equity

George Deeb, managing partner at Red Rocket Ventures,  provided his opinion about equity financing in his article--Comparing Equity, Debt And Convertibles For Startup Financings. You may follow George on Twitter at @georgedeeb

"Advantages:  Does not have to be repaid, like debt does.  Gives certainty of valuation for your company which can also be a disadvantage if the value is too low (for diluting founders' stake) or too high (which can impact interest from next round investors who do not like to price downrounds from the round before, to avoid legal risks from diluted shareholders).

Disadvantages:  The most complex to structure (highest legal bills, longest time to close).  Usually involves giving some level of board control to investors."

 

Straight Debt Platforms

Debt crowdfunding platforms tend to charge lenders a fee of 1-7.5% per loan. Annual percentage rates can vary hugely, but generally speaking, lenders receive interest of 5-12% per year (see Table 2 below for information on a number of selected lending platforms).

 

Name

Key Metrics

Fees

Loans funded so far

Interest Rate

Fees

Funding Circle

More than $800,000,000

5.99%-14.74%

2.99%

Lending Club

$7,620,367,965

5.93%-17.86%

1.11-5%

Prosper

$ 2 billion

6.73%-35.97%

1-5%

Zidisha

$2,776,865

N/A

5%

Table 2: Sample Of Business and Project Debt-based Crowdfunding Market in the USA

Resources: http://www.toniic.com/wp-content/uploads/2013/12/CrowdfundingForImpact.pdf

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