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Last Updated:
December 21, 2020

The Angel Convertible: A Flexible Option for Angel Investors

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The Angel Convertible: A Flexible Option for Angel Investors

Convertible debt deals are popular among Angel Investors.

However, not all Angel Investors are familiar with this funding option. The deal structure is becoming popular and catching up with entrepreneurs and Angel Investors who want more options for funding promising startup businesses.

What is an Angel Convertible?

Also known as convertible debt or a convertible note, it is a short-term loan that converts to equity when the startup raises the next round of funding or on another “qualifying transaction”, usually within 12-18 months. Other qualifying transactions can be sales, liquidations or other forms of exit of the business.

The convertible note defers the company's valuation to the next round of funding. Other provisions in convertible notes are interest rate (usually 8% to 10%), maturity date, discount rate (the percentage discount from the valuation in the next round that the investor will receive when their shares convert), valuation cap (the maximum valuation that the investor will convert in at). This also serves as a default valuation in the event that no further priced funding rounds are done. 

Convertible debt is a popular financing option for startups that choose to raise $500k or less, and they are more common in markets outside of Silicon Valley. Usually, the money raised in the early rounds of financing (between $50,000 and $2 million) is not enough to justify the legal fees needed for preferred stock financing (commonly known as a “priced round”).

After raising convertible debt, a subsequent qualified liquidity event or financing round triggers conversion of the debt (inclusive of the interest) into equity, typically into preferred stock.

A convertible note may convert at the same price an investor pays in the next financing. It may also convert at either a discount or a conversion price based on a valuation cap.

Valuation caps and discounts incentivize investors to invest early; they avoid setting a price on the equity when it would typically be lower. 

The convertible debt and interest can be paid with equity when it falls due. Alternatively, it gives the holder a right to be repaid in cash like a standard loan.

Convertibles debt rounds can be as small as $50 - $100 or more, but usually below $500K. An entrepreneur can sell common stock or convertible equity to raise such small amounts, but convertible debt is still popular.

Another provision is a cap on the valuation price for noteholders when the loan converts to equity and a discount rate on the share price when the note converts.

Key provisions

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The 3 key provisions of convertibles

Let’s walk you through some key provisions of convertibles.

1. Discount rate 

A discount rate establishes how much compensation noteholders get for the additional risk they take for supporting very early-stage companies.

A conversion discount enables the holder to purchase their equity at a price discount when the note is converted into stock. The discount is usually 10% - 20% but can go higher.

If the note is executed with a 25% discount, the Angel Investor receives a higher return.

For example, if investors are paying $1 per share in the next round, the note will convert to $0.75 per share. On a $100,000 convertible note, it buys you 125,000 shares, which is effectively a 25% premium.

That's a fair reward for investing in early.

Discounts are common in convertible notes that Angel Investors can ask for when considering a convertible note offer.

2. Valuation Cap (Conversion Cap)

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The cap sets the maximum valuation of a company at which an Angel Investor's note can convert into a company's stock. It protects early investors from high valuations in the next round of fundraising where the effect would be to dilute the Angel Investor significantly. 

Here is an example.

An Angel Investor makes an investment of $50K in a convertible note without a valuation cap. 

According to the terms, the debt will automatically convert into equity when the company raises $1M in equity in qualified financing (fixed price financing)

The company raises $1M in qualified financing at a valuation of $20M with a price per share of $1.

Without a valuation cap, the Angel Investor's stock would convert at the $20M valuation at the $1 per share. 

But, let's assume there was a valuation cap of $5M on the convertible note.

A conversion cap sets the maximum valuation level at which the Angel’s investment will convert into equity at $5M for the next round. So if the next financing round values the company at $20M the angel will convert at $25c per share for the same shares as the other investors.  

The effect of the cap prevents the investor from having their share diluted  if the next round of financing is much higher - say $10M or $20M.

The Angel investor's note would convert at a much better price per share, and the investor would get more shares - not so diluted.

According to Forbes, Angels in the past have not liked convertible notes because, without conversion provisions, they would take more risk without the potential for reward.

Such provisions make convertible debt more friendly to both Angel Investors and entrepreneurs. Angel Investors receive a fair reward for investing early in risky deals, and these innovations offer terms with more options.

3. New market innovation - Convert to Equity.

Convertible notes have attracted new market innovations adding even more options and upsides for Angel Investors.

In case the company is acquired before the note converts, the provision allows a noteholder to convert to equity.

An Angel Investor may use a 1X or 2X liquidation preference to get a return in such a case. For example, if the Angel Investor invests $25K with a 2X liquidation preference, the return would be 2X their money before they or anyone else start to participate in the split of the proceeds of the liquidation. 

How startups benefit from a convertible debt

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4 ways startup can benefit from convertible debt

Startups can benefit from a convertible debt in the following ways;

Immediate access to money when a startup is short of cash or needs additional funds.

Convertible debts require lightweight documentation - It means startups can easily execute the note. Legal costs are also significantly less.

Ability to attract more early investors - Startups can reward investors who come into the deal early in addition to the general accumulation of interest. Such rewards include a valuation cap, discount rate on conversion, or a combination.

Ability to delay company valuation - Convertible debts allow startups to delay setting a pre-money valuation on the company. For example, a very early-stage startup can find it challenging to convince an investor that it is worth $5 million. 

However, issuing convertible notes can delay a valuation until the first priced equity investment; hopefully, the company will have progressed. 

The valuation cap effectively puts an upper limit on the value if included in the convertible note.

How angel investors benefit from a convertible debt

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A convertible note can still be better than a fixed priced equity round

Angel Investors often complained that convertible debts prevented them from getting fair compensation for the additional risk they took by investing in very early-stage companies.

However, a priced round allows Angel Investors to lock in a low cost for their shares. A valuation cap as a feature makes convertible debts more popular, even though some still don't like convertible debts.

But a convertible note can still be better than a fixed priced equity round, and here is why;

  • In case a company goes down, debt holders get their money back before other equity holders.
  • Noteholders get favorable conversion provisions such as caps and discounts. They can optionally convert if the company raises money in non-qualified financing at a lower  valuation than otherwise.
  • Convertible noteholders can charge interest. You can even charge higher interest rates when the note is past due or the company defaults on loan terms.
  • They can have warrants appended to their notes as an additional benefit to their investment.
  • Noteholders can take a security interest in company assets.
  • They can obtain legal, contractual rights like board seats, observer rights, information rights, pro-rata, or participation rights.

In summary, an Angel Investor can do just about everything they can imagine - all in a relatively short document.

Flexible interaction between valuation caps and discounts

If a convertible note has both a valuation cap and a discount, the convertible note should read that you get the better of two conversion possibilities. 

If you would get more shares at the discounted price, then you would take the discounted price. If the valuation cap price gets you more shares, you'll convert at the valuation cap price.