Convertible Equity–An Idea Whose Time Has Come

1932 Nash Advanced Eight Convertible Sedan

1932 Nash Advanced Eight Convertible Sedan (Photo credit: aldenjewell)

In my last company, Advanced Diamond Technologies, there was a time between equity financing rounds when we needed bridge financing. This is very common among young companies. I don’t recall now the circumstances under which we needed to raise money quickly, but it has always been the accepted wisdom that if you need to raise money quickly, use a Convertible Note.

A Convertible Note is a loan to the company made by investors. In our case we tapped existing investors. To avoid the transaction costs of an equity financing, and to avoid the need to negotiate a valuation on the company with the equity investors, a Convertible Note essentially says the following:

  • We (the investors) will loan you the money
  • You will pay us back when you do your next equity financing
  • At that time, when the valuation of the company is determined by new investors, we will convert what you owe us (plus interest) into shares of the company at the negotiated price less a discount (to account for the fact that we’re investing now, not then).
  • And if you don’t raise new money during a specific time frame [this is highly situational¬†and could be anywhere from 90 days to two years], we get our money back plus interest. In other words, we can demand repayment and foreclose on your or take over your company if you aren’t able to repay. At the very least, we will extract a huge pound of flesh when converting the debt you owe us into shares of your company.

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