Is There Value in Debt for Early-Stage Technology Ventures?

by eramsay on October 13, 2011

Debt may be a valuable step to conversion from a non-dilutive funding model to an equity financed start-up

Consider this scenario. You are an entrepreneur with an early-stage venture. Emerging from stealth mode, you make it your mission to speak to as many of the great and the good in the community to lay the groundwork for a future Series A financing. (Un)expectedly, someone immediately recognizes that after implementation of your technology – the world will never be the same.

They want in. And they want in now.

If you take the money now what will you offer in return?

Providing equity in return for seed financing necessitates valuation of the company. Issue stock now at the current valuation and dilution could be exacerbated in a future Series A financing. This provides a dilemma for entrepreneurs of early-stage technology companies, particularly when a significant value bump is anticipated upon completion of defined short-term milestones. Enter an alternative financing option: convertible debt.

Convertible debt (often referred to as convertible notes or loans), is where the company borrows the money with the intention of converting the loan to stock at a later pre-determined time. This option avoids company valuation and is often associated with lower legal fees – good news for early-stage companies.

Where’s the value for investors?

For investors, debt is most likely considered in the above scenario where the desire to invest in the company is balanced with the realization that the company is unlikely to accept the money at the current valuation. The investor is compensated for accepting convertible notes by the provision of discounts, or a warrant.

Discounts enable the debt to be converted to stock at a pre-determined discount at the next financing round. For example, in our scenario, if the seed investor agreed a convertible loan with a discount of 20%, and the Series A stock is valued at $1.00 per share, the debt will be converted to stock at a cost of $0.80 per share. If the loan was for $100,000, the seed investor would be issued 125,000 shares ($100,000 divided by $0.80) representing a value of $125,000.

A warrant is often referred to as a warrant coverage percentage. In contrast to a discount, the compensation percentage is applied to the value of the loan, not to determine the cost of a share. For example, a warrant coverage of 20% on a $100,000 loan would entitle the holder of the convertible notes to receive an additional $20,000 of securities at the next financing representing a total value of $120,000.

Learn more about convertible debt

For a more educated description of discounts, warrants, conversion caps and all things convertible debt, I would direct the reader to the excellent posts herehere and hereFred Wilson describes why as a VC investor he generally does not favor taking debt in early-stage companies, and also provides an example where convertible debt proved valuable for a late-stage entity.

Debt an option for early-stage biotechnology companies?

For early-stage biotech companies operating capital-efficient models to develop proof-of-principle data and create value, such as the “leverage start-up“, seed financing as convertible debt offers a bridge between non-dilutive funding and Series A financing. This is particularly valuable when covering activities that are not eligible grant expenses, but have an impact on short-term milestones that will significantly increase company valuation.

Have you used convertible debt to finance your early-stage venture? If so, I would love to hear your experience. Please comment below.

This article was originally posted on scideation.org

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