What is Equity Financing?
Equity Financing is a process wherein the company sells its shares to the investors to raise the capital. In exchange investors receive an ownership stake in the company, represented by shares of stock.
Equity financing is often used by companies to fund growth, expand operations, develop new products, or enter new markets.
Key aspects of equity financing include:
Ownership: Investors to whom the shares are sold in the process of equity financing, become part owners of the company. Their ownership is proportional to the number of shares they own out of the total shares.
No Repayment: The company does not have to repay the money raised through equity financing. However, investors do expect some returns on their investment made, maybe in the form of capital gains when the company grows and its value increases, or through dividends.
Dilution: When new shares are issued, the percentage of existing shareholders can be diluted. This is known as dilution and is a common consequence of equity financing.
Risk and return: Investors take more risk in equity funds because they earn money if the company makes a profit. However, if the value of the company increases significantly, the return on the debt fund may be higher.
Funding Types:
Private equity: Usually used by startups or private companies, selling shares to private investors, venture capitalists, or angel investors.
Public Method: For listed companies, financing involves the purchase of shares at a stock price through an initial public offering (IPO) and a subsequent offering.
WHAT IS A CONVERTIBLE NOTE?
A convertible note is a type of short-term debt that converts into equity, typically in connection with a future financing round (such as when a startup raises venture capital). Instead of receiving a return on their investment through interest payments, investors who hold convertible notes are repaid by converting their loan into ownership in the company (equity).
Convertible notes are common in early-stage startup financing because they delay the need for a valuation and provide flexibility in structuring future financing rounds.
Some of the important terms related to Convertible Notes are as follows-
Debt Instrument: Initially, the convertible note is structured as debt, where the investor lends money to the company, often with an interest rate and maturity date.
Conversion to Equity: Upon a trigger event (usually a future equity financing round), the debt is converted into equity, which indicates that the investor receives shares in the company.
Discount Rate: Investors usually get a discount on the share price when the note converts into equity.
Valuation Cap: This sets a maximum valuation at which the note will convert into equity, protecting early investors from paying higher prices when the company grows rapidly before a formal valuation.
Interest: Convertible notes typically accrue interest and the same is often converted into additional equity at the time of conversion.
Maturity Date: Convertible notes usually have a maturity date, and if the note doesn’t convert before that, the investor may demand repayment or conversion into equity under certain terms.
How Convertible Notes Work in Equity Financing?
Convertible notes play a unique role in equity financing by acting as a hybrid between debt and equity. They allow companies, especially startups, to raise funds quickly and flexibly before deciding on a formal valuation of the company.
Here’s how they work in equity financing:
1. Originated as debt: A convertible note begins as a debt instrument, meaning that the investor receives the money under certain conditions. to the interest rate and maturity date of the loan. to the company.Instead of paying principal and interest, the note is designed to convert to equity (company equity) in a future financing round.
2. Conversion into equity:The main feature of a convertible certificate is the conversion into equity (shares) when the company conducts a future financing round, usually in when a formal value is determined.For example, if a startup raises capital through equity funding in a Series A round, the amount owed to equity holders of the convertible bond (including interest, if any) is converted to share at a reduced price.2.
3. Discount on Share Price:
To compensate early investors for taking on additional risk, the note typically includes a discount rate (often 15–25%) on the future equity price. This means that when the note converts, the investor buys the equity at a lower price than new investors in the subsequent round.
Example: If the Series A round sets the share price at $1.00, and the convertible note has a 20% discount, the note holder will convert their debt at $0.80 per share.
4. Valuation Cap:
A valuation cap protects the note holder by setting a maximum company valuation at which their loan will convert into equity. This ensures that the note holders don’t get diluted too much if the company grows quickly and is valued much higher in the next funding round.
Example: If the valuation capital is $5 million, and the company is valued at $10 million during the equity financing, the note holder’s shares will be converted as if the company were valued at $5 million, giving them more equity.
5. Interest Accrual:
Convertible notes often come with an interest rate (e.g., 5–8%). Instead of paying out the interest in cash, this interest accrues and is added to the principal loan amount, which also converts into equity at the next financing round.
Example: A $100,000 note with 5% annual interest would become $105,000 after one year, and this total would convert into equity.
6. Maturity Date:
Convertible notes have a maturity date (typically 12–24 months), after which the company must either repay the loan or convert the debt into equity, even if a formal funding round hasn’t occurred.
In some cases, investors can choose to demand repayment if the company doesn’t raise additional funds by the maturity date, though this rarely happens in early-stage startups.
Example of How Convertible Notes Work in Equity Financing:
Let’s assume that a startup raises $500,000 through convertible notes with a 20% discount and a $5 million valuation cap. After a year, the startup raises a Series A round with a valuation of $10 million, and new investors buy shares at $1.00 each.
Since the valuation cap is $5 million, the convertible note holder’s investment will convert as though the company were valued at $5 million, not $10 million.
The note holders would convert their $500,000 into equity at a share price of $0.50 (instead of $1.00), meaning they receive twice as many shares compared to new investors.
Benefits of Using Convertible Notes in Equity Financing:
For the company: Convertible notes offer a quick way to raise funds without needing to establish a formal company valuation, which can be difficult in the early stages.
For investors: They offer the potential for significant upside (due to discount rates and valuation caps) if the company grows rapidly, they also have some downside protection because the investment begins as a debt instrument.
CONCLUSION
In conclusion, convertible notes offer a flexible and efficient way for startups to raise early-stage funding without needing an immediate company valuation. They act as a hybrid between debt and equity, converting into shares during future financing rounds, often at a discount or with a valuation cap to reward early investors for their risk. These notes benefit companies by providing quick access to capital and investors by offering potential upside with downside protection. This mechanism is popular in the startup ecosystem because it simplifies fundraising and aligns the interests of both founders and investors.