Convertible debentures and early round equity financing

Equity financing refers to raising capital through sale of the company’s shares and/or other securities. In technology startups, the class of shares offered to investors will typically be created as part of the financing and will be specifically tailored to the investors’ needs. When issuing shares during any stage of funding, you must comply with applicable securities laws and should seek advice from legal counsel before proceeding.

Early-round equity financing

Early-stage investors tend to use convertible debentures, common shares and warrants for seed or first rounds of investing. Convertible debentures are discussed below. Sophisticated later-stage private investors traditionally use other types of equity instruments.

Convertible debentures (non-valued investment)

A convertible debenture consists of a debt instrument (debenture) with:

• A maturity date
• An interest rate
• Security for investors on all of the assets of the corporation, including the intellectual property

For seed rounds, security rights of investors may include the assets of the founders.

Convertible debentures differ from traditional debt. 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 at a price equal to (or at a discount of typically 10-30%) to the price of and on the same terms as the shares that are offered to the new investors.

This type of deal has become the frequent choice of angel and other groups who are providing seed funding to start-ups that expect to seek additional funding within a year of the initial investment round.

Convertible debentures: The pros

A convertible debenture is a non-valued investment. The benefit for founders/management is that deferring the value of the business may enable founders/management to increase the valuation beyond the amount of debenture financing. This can reduce the dilution to your ownership.

Convertible debentures: The cons

1. There is a risk that despite progress of the business, market conditions for financing may be worse when valuation is negotiated for the next round.
2. If a subsequent financing round is not raised by the maturity date of the debenture, the early round investors will have the ability to exercise their security and manage the business for purpose of liquidating the assets to repay their debenture.
3. The investors may sit in a strong negotiating position with your business as you try to negotiate the conversion price for their debenture and interest into equity to avoid obligation to repay the amounts.

The investor’s view

Investors prefer to use a debenture in seed rounds when they believe it is too early to determine a valuation. Also, existing investors may use the debenture between financing rounds to fund operations until your business’ next round of funding is complete without setting an interim valuation on the business.

References

Canada Business. Retrieved April 9, 2009, from http://www.canadabusiness.ca.
VC Experts. Retrieved April 9, 2009, from .
Houston, T., Johnson, A., & Smith, E. (2006, September 15). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Retrieved April 9, 2009, from Fraser Milner Casgrain website at http://www.techstartupcenter.com/