Fewer startups are content with traditional equity: here’s why

For many startups looking to raise venture capital, it looks like traditional equity is no longer enough.  More and more startups are looking at convertible notes or other debt alternatives.

By Andrew Woodman

Earlier this week, CB insights noted a 700% increase in the dollars raised through convertible notes – that’s basically loans that convert into equity at later rounds – in the US between 2014 and 2015.

Tech Berlin noted that the trend has been growing in Europe for a while, writing,  “The economics are the same in Europe, and investors are quickly adopting this tools as well.”

The craze is dampened a bit as the VC industry takes its foot off the gas, but it is remarkable to see how fundraising habits have changed.

Here are some of the reasons why.

1. Convertible notes change to equity later.  So it is ideal for early stage startups that have not received a valuation. This makes the whole process quicker, and it also means it is cheaper thanks to fewer legal fees.

2. Because of this, startups find it easier to raise smaller amounts of cash more often.

3. The benefits are not limited to small businesses.  For larger startups, it is a way to postpone renegotiating terms with investors.  This is handy if the company is going through a rough patch.

It is no surprise that this trend is reaching the Nordic startup scene.  As raising funding in the Nordics tends to take longer than in the US, and investors are more risk averse, founders often spend much more time raising money – time that could be spent building their business.

Investors have an advantage

There are advantages for investors too.  For example, note holders will typically get discounts or valuation caps on the converting balance.

There is also added downside protection for investors coming in at the early stages.  But there are disadvantages too. Investors typically won’t hold as much influence without equity.

Also, convertible notes might might seem like a good idea when the going is good, but when things go bad – like a down round – investors will ask for their money back.

It can get messy, but it depends on the terms.  For the startup, the worst case scenario is what’s called full ratchet”.  In that case, a down round will mean the equity re-prices to a lower price per share.  In the current climate, startups might want to be more cautious.

 

Additional reporting by Lisa Mallner.