Tech businesses will almost invariably need some type of investment to help fuel their business. Two of the most prevalent types of financing tech entrepreneurs seek out are debt financing and equity financing; each has its own advantages and disadvantages which will be discussed briefly below.

What many entrepreneurs don’t know, or don’t learn until it’s too late, is that there is a hybrid financing option that combines both debt and equity into an investment vehicle many refer to as “non-valued instruments” or “convertible debentures.”

Debt financing is relatively straightforward. A VC will loan your company an amount of money for a stipulated amount of time. In return, the VC profits from the interest you pay on your debt. Equity financing can be more complicated, as there are numerous ways that a business can structure its shares. In general, we can say that equity financing involves an investor giving your business money in exchange for shares in the company and/or some other security.

Convertible debentures mix features of both equity and debt financing. A convertible debenture is essentially a secured debt that has a maturity date and an interest rate. Because convertible debentures are popular in early-stage investment rounds, they will usually be secured against all of the corporation’s assets, and even sometimes against the founder’s assets.

What happens next is what truly sets a convertible debenture apart from a traditional debt-based investment.

As MaRS explains, “the principal of the debt plus all accrued interest will be converted into the class of shares offered to new investors in the next round of financing”. This will be done either at the same price as the new investors pay, or at a discount, depending on the terms of the convertible instrument.

Essentially, both parties are taking a gamble when they use convertible debentures to fund a start-up; what they are doing is deferring the valuation of the company until the next round of financing.

The entrepreneur is hoping that they get a “good deal” on this early financing round – in other words, that they achieve a higher valuation in the next round of financing than they would have gotten in the initial round. This would mean that the second round of financing will be quite large and thus the amount of shares given to the initial investors will be minimal. The investor hopes to benefit from a discount in the price of the shares sold in the second round of financing, to get an early share of a fledgling business that they think may be extremely successful, and to avoid having a deal hold up by negotiations over valuation.

Since the emergence of these convertible debenture instruments, many investors have worked hard to find ways of making them more beneficial to them and less beneficial to entrepreneurs. One of the ways they have done this is by introducing the idea of a “cap” on the next round of investment.

This means that the maximum valuation for the next round of investment is capped at a certain number. This way, the investor knows with certainty the bare minimum equity they will be receiving in the company. To borrow an example from Mark Suster  we can say that if an investor writes a cheque for $500,000 into a convertible note with a $4.5 million cap, the investor knows they will at least get 10% of the company.

This is dangerous for entrepreneurs, because there is no minimum set in these circumstances. For instance, if the next round of financing in our example valued the company at $1,000,000 the first investor would own half the company. Indeed, this is very similar to anti-dilution or full ratchet clauses in standard equity term sheets that entrepreneurs are so keen to avoid.

Before undertaking any type of financing, it is best to consult with a lawyer to ensure that you understand the specifics of the deal being offered to you. Many entrepreneurs are not in a position to be selective about the financing they take and wind up signing deals they do not understand because of this lack of bargaining position. These entrepreneurs may get funding, but may be in for some serious headaches down the road.

October is small business month and to celebrate, writers from Aluvion Law will be making daily posts on one of the most common forms of Small Businesses: Corporations!  Corporations are particularly popular among the high-tech and IT crowd because of the tax advantages they provide to rapidly growing companies, as well as the assistance they can provide in unlocking capital. The other great benefit recognized by the ‘serial entrepreneurs’ that flock to the IT sector is that they limit the liability of the owners in the event of the business failing.

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