Concept demystified practically
CNs — the concept
CNs are an alternative to the priced rounds, wherein the funds being infused by the investors are converted at a valuation which is not pre-decided, but dependent on subsequent funding rounds.
CNs — when it is used
There are 2 use cases where CNs trigger (a) first when the funds are being raised by the startup at an early stage (b) second when there is a delay in an institutional round in later stages of startup and some investors are brought in (or maybe existing investors) to bridge the gap
How CNs help in raising funds at an early stage
Every startup at an early stage is confused on the round raising strategy i.e. whether to undertake a priced one or a convertible round (SAFE if we consider YCombinator documents). While there is always a push by the founders to have an increased valuation number, the investors always look for a lower valuation, especially in a pre-revenue stage of the company (or when POC is just in the market and is gaining validation). the decision to arrive at a valuation number is all commercial, but the early stage of the company results in investors struggling to arrive at a valuation number for putting in the investment. More so, the investors are all angels, family & friends, etc who may be putting in money on the founder of the company but have no capability to ascertain if the valuation of the company as arrived by the founder is reasonable at that round
explaining this by way of an Example — A priced round is generally at a specific valuation i.e. raising USD 500k at USD 5 Mn post-money valuation. In this case, the investors will get 10% equity in the company. Now, what if the next round happens at USD 4 Mn pre-money, which means that the earlier investors who invested early in the company at USD 5 Mn post-money (USD 4.5 Mn pre-money) were at a disadvantage. They invested at a higher valuation and are not going to get any advantage of the down round valuation. This uncertainty is removed by having a convertible round i.e. raising USD 500k at a valuation cap of USD 4.5 Mn Pre-money and a discount of 15% to the next round of funding. Now continuing the above example, if the company is securing the next round of equity financing at USD 4 million pre-money, the earlier investors valuation will be decided at a 15% discount to $4 million that is $3.4 million. The angel investors are better off in a convertible round as they will always have atleast a delta of 15% on the startup’s next fundraising valuation.
How CNs help in raising funds in bridge rounds
The second area where CNs are useful is when the fundraising reaches the growth stage of a startup, but still, institutional investors are either doing a wait and watch or the runway gets shorter with founders looking at someone entering and bridging the gap. In these cases as well, the CNs can come useful. This gives the advantage to CN investors to get a delta on valuation coming from the next fundraising and at the same time, the fact that the company is now at a growth stage also gives certainty of the next round happening. The bridge gets closed quickly as compared to the priced round which takes several rounds of negotiations, due diligence, etc. Mostly, the bridge with CNs happens with existing investors coming on board in the round or small investors pitching in.
Other advantages at Play
No need for detailed shareholder agreement — including clauses like anti-dilution / liquidation preference, etc
Round need not be completed before getting the first cheque
while we have discussed above the fact that the CNs are either preferable in the early stages of the company or when the next round is certain of happening but the uncertainty is on the runway. there is one more advantage that merits attention. The round can continue to happen over a period of time and we need not wait for the entire round to get closed first and then move forward with documentation and closing.
Without even the round, the valuation caps can be increased
We have seen companies running rounds on multiple times and it can even go on and on for 6 months +
For example; the round can go as below
USD 100,000 raised at USD 5 Mn Cap with 20% discount
USD 50,000 raised at USD 7 Mn Cap with 20% discount
USD 150,000 raised at USD 10 Mn Cap with 20% discount
So, with changed metrics, the company can infact step up the valuation as well
Important items to take care of in CN
- Whether the conversion is parallel to the next financing round or prior to that. Both results in different %age for the CN investors and the subsequent investors as well (coming in the next financing round). We faced challenges with subsequent investors with CN having conversion terms “parallel to the next financing round”. So the same was finally changed to “prior to the next financing round” after seeking approval from CN Investors
- If CCPS and CCDs are being issued to Non-resident Investors to reflect CN terms in the Indian context, valuation certificate for FMV purposes under FEMA is tricky considering the valuation linked to subsequent financing is entirely unknown. Adding a notional coupon rate on the CN note till the next financing round adds up to the complexities.
- There is also a “floor” (apart from Cap) that can be factored in the commercial arrangement. But the floor fixes the valuation below which the CN cannot convert. The problem with the floor is that
- The period of holding for capital gains tax is required to be counted from the date of acquisition of shares. Now, CN is being considered as share application money or debt, which means that period of holding will not start till the time actual conversion happens into shares
- Transfer of Shares of an overseas company by any Indian resident or Book value
Regulatory issue
India — CNs are a nuisance
The next problem is in the Indian context. there are multiple regulations that play when you raise funds through convertible notes. You can read in detail at the link https://bit.ly/32dL0pq
Summarizing few of the issues;
- The startup should be DIPP registered — quite unnecessary
- There is a limit of 25 lacs to be infused by each investor for the CN — this is tricky as angel rounds in India happen with less amount being infused by individual investors
- The CN needs to be converted into Equity shares (though some firms take a view that it should cover Preference shares as well, but) — if someone reads strictly, this also becomes a problem. Post CNs, whenever a new round is happening, in some cases, the CNs convert into the same class of shares as the new round is happening. Even if that is not happening, the CNs convert into a different class of shares (other than equity) because they still need to preserve certain rights in terms of anti-dilution and liquidation preference. CN is just a placeholder and being used
These requirements make it a problem in structuring the round / fundraise in India.
the government has laid down the regulations but made it problematic for any startup to raise funds through CN. They show that they have heeded to the suggestions of the venture capital industry, but the regulations were ill-conceived.
So most of the CN structures being implemented in Indian startups are by way of CCD or CCPS, wherein the conversion formula includes the cap and discount formula. This still makes the entire transaction complex considering that CN was originally thought of being entered through a plain agreement, but with CCDs and CCPS coming into picture, this makes it impossible to keep it at all simple. The entire gamut of compliances like Private placement under Company law, RBI filings, stamp duties, etc gets triggered. The intent of keeping the round simple is all lost.
Singapore and US — it’s not et all complex
In these countries, this is much simpler as the entire CN framework can be executed without going through initiating Corporate actions. there is no issuance of shares or debentures. An agreement is executed and gets implemented. This in turn makes the entire fundraising process a breeze, cost-effective as well for early-stage startups. One reason as to why a lot of startups look at inverting their structure outside of India
In the US, there is also an option to select CN or SAFE notes. Most of the terms are similar except that CN is more of quasi debt, while SAFE is a kind of share application money (can see it as CCPS in the Indian context).
Conclusion
There is no doubt that CN is the best way to move forward for closing deals quickly, but need to be aware of the regulatory issues surrounding it. This also brings to another important question that a Cap table may have CNs outstanding, and without factoring those CNs, the same may not be giving the right picture. In other cases, CNs are reflected on an FDSC basis by converting them to Caps (assuming that the delta between the valuation in the next financing round and the Cap shall be atleast the discount %age set). But what if the discount gets triggered — the Cap table will change as CN holders will acquire more %age. In that case, if the anti-dilution of earlier investors also triggers, Cap table changes will be substantive.
Since we are talking so much of maths, I am just thinking of getting some examples on excel to showcase what will happen.
Convertible (CN) is more than just deferred valuation was originally published in Diary Notes of a VC lawyer on Medium, where people are continuing the conversation by highlighting and responding to this story.