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Convertible Debt
Raising
Money
Questions such as:
• How do you
raise money?
• Whom do I approach to raise money?
• How do I approach these people?
Most entrepreneurs believe there are only two methods of
raising money:
1) Approaching a lending institution and acquiring debt
But using debt can be a high risk exercise:
a. Most lending institutions will need collateral against
the money they will lend you. Collateral is property that is
deemed acceptable as security for a loan or other
obligation. In most cases, the only property acceptable for
a loan for a new business is the owner’s personal property.
And risking your personal property against your business’
debt is considered very high risk for most people.
b. As many businesses fail, lending institutions usually
charge a high rate of interest against the loan to leverage
their losses. Some banks will charge as much as 18% on loans
greater than $100,000. Paying back the interest on the loan
can be extremely challenging to a company just getting
started.
2) Selling equity in your business
This can cause you to lose ownership and control of your own
company Equity (stock or any other security representing an
ownership interest) can raise many more questions:
a. How much is
my business worth right now?
b. How much equity do I give investors?
c. How much control of my business do I give investors?
The answers to these questions can affect your ability to
raise money and relationships with your investors for years
to come.
ANOTHER ALTERNATIVE
Convertible debt is the ability for a small business to
issue a loan, or debt obligation, to investors. But this
loan can be turned into equity generally when the small
business obtains future financing or generates a target
revenue number.
It is very difficult to determine the current worth of your
business, and this determination is usually when the deal
falls through. Convertible debt is an excellent way to raise
funds without setting a valuation on your business, as well
as protecting early investors from dilution in the next
round of the company’s financing. Below, is an example
of how
convertible debt is more attractive to early investors than
giving them equity in exchange for their investment.
In Scenario 2, Company B avoids the need to set its
valuation before an institutional investor (VC) comes in.
Determining how to value a startup is notoriously arbitrary,
and entrepreneurs raising money from relatives and friends
tend to over-value their new businesses. Convertible
debt eliminates the risk of a “down round” (an investment
round with a share price lower than the previous round)
Scenario 1 - Company A
Equity Sale PRICED ROUND TODAY
Company A needs $500,000
Angel Investors agree to invest $500,000
Company A and Angels agree on a
$4,500,000 pre-money valuation
Thus, post-money valuation = $5,000,000.
Post-money valuation = pre-money valuation + amount of
raise. Angel Investors now own 10% of Company A
9 months later....
Company A needs another
$2,000,000. Venture Capitalists agree
to invest $2,000,000
Company A and VC firm agree on a
$2,000,000 pre-money valuation
Thus, post-money valuation =
$4,000,000. Angel Investors are diluted
by 50%
Scenario 2 - Company B
CONVERTIBLE DEBT PRICED
ROUND FUTURE DATE.
Company B needs $500,000
Angel Investors agree to invest $500,000
Company B and Angels agree that
investment will automatically convert
into equity at a conversion price to
be set later by the lead investor of
the next equity round of Company B
The convertible debt will convert at the same price and on
the same other terms as the lead investor in the next equity
financing. Angels can also be compensated for putting their
money in earlier by getting warrant coverage. Which gives
them a chance to buy additional shares in the next round
9 months later...
Company B needs another
$2,000,000. Venture Capitalists agree to invest $2,000,000
Company A and VC firm agree on a $2,000,000 pre-money
valuation
Thus, post-money valuation = $4,500,000 (we add the $500,000
of convertible debt as part of the total raise). Angel
Investors experience no dilution
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