30 July 2018

Seed Funding – Convertible Note v. Convertible Equity

We fear that at this point in time, it remains a case of “beggars can’t be choosers” for most start ups seeking funding in Australia, at least until such time as more inviting incentives are put in place by our legislature for investors. Nonetheless, we are seeing increasing interest in Convertible Equity as an alternative to the traditional Convertible Note investment method.

Our experience with start up funding is that the preferred method of investment is still by way of Convertible Notes. A Convertible Note investment most commonly involves the investor lending a sum of money to the start up company on the basis that the start up company pays interest on the loan, and then by a certain date (Maturity Date), the investor can choose to convert the loan to shares, usually at a discount of 15-20%, or require the start up company to repay of the loan. Harsher arrangements we have seen also involve the founders personally guaranteeing the repayment of the loan.

We have observed some criticism (mostly from more advanced markets like the USA) of the Convertible Note model, given the position it can put the start up company in. As we have advised start ups raising in this way, the parties are activating a ticking time bomb, because when the Maturity Date comes, if the start up hasn’t been able to raise further funding or advance the business as quickly as first planned, the results can be disastrous. Insolvency is often the only alternative to harshly renegotiated terms with the investor.

An alternative investment method known as Convertible Equity is gaining popularity in more mature seed funding markets than ours. This involves the investor being granted a right to preferential shares upon the occurrence of a specified trigger event.

“The main difference to Convertible Notes is that with Convertible Equity, the investment does not need to be repaid and it does not accrue interest.”

Although this sounds only good for the start-up, savvy investors will see the benefit in it also because if the start up is not saddled up with interest bearing debt, which makes it more difficult to obtain lines of credit and undertake later fundraising stages, as well as include it in the balance sheet, there is a higher chance of success.

Our commercial lawyers have extensive experience advising start ups, investors and fund managers. If you have any queries in this space, we would love to talk.