11/26/2023 0 Comments Convertible notes venture capitalIn most types of preferred stock, the liquidation preference means that in a liquidity event, the investors get the value of their investment back, plus any preferred dividends, prior to the rest of the funds being distributed amongst the % ownership. When the investment is structured as preferred stock, this typically comes with terms such as a liquidation preference, a preferred dividend, and approval rights over certain company decisions. Most equity investments in venture capital-backed companies are structured as preferred stock, which is different than simply $X for Y% of the company. Another key point about equity investments is that because the investor is a part owner of the company, they typically have some sort of voting rights that govern various decisions of the company. In a typical venture capital investment, an acquisition or IPO is almost always the way that investors make their money, with distributions of cash flow being a rarity. When a company raises funding by selling equity, there is no set schedule for the investor to get repaid, and the investor generally counts on making their money back, plus a return, in a future liquidity event (such as an acquisition of IPO) or through distributions of future profits. In an equity investment, a company sells a percentage of their company (equity) for a sum of money. When most people think of an investment, they are thinking about equity. While everyone knows that an investor gives money to a company with the goal of getting more back in the end, there are many different ways this takes shape in practice. I will first give a brief overview of the basic concept of a convertible note and how it has some attributes of both debt and equity, and then I will look at the pros and cons of this form of financing. However, before going down this path, it is important to understand the potential pitfalls of this type of financing and whether or not it is the best choice for your company. In this article, I am going to look at one of those major decisions that most entrepreneurs and companies must face when they are raising investment funds and that is the pros and cons of using convertible notes to finance your company.Ĭonvertible notes (sometimes called “convertible loan notes” or “CLNs”) have become increasingly popular in the world of startup financing, particularly in seed stage companies. While identifying a viable market and making a great pitch are crucial to raising investment funding, there is a seemingly endless array of other considerations that need to be addressed before those funds show up in your bank account and you are off and running to create the next big thing. The vast majority of high-growth startup companies rely on some form of outside financings such as funding from angel funds, traditional venture capital, high net worth investors, or friends and family. Certain clauses such as the valuation cap and the conversion discount can complicate future equity raises by anchoring price expectations.To avoid the above, terms and conditions can be set that, if taken too far, defeat the purpose of the convertible note and end up taking as much time and effort as a traditional equity round.If future equity rounds are not completed, the convertible note will remain debt and thus require redemption, potentially pushing still-fragile companies into bankruptcy.
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