One question I frequently receive from our syndicate investors is “How many shares of stock am I buying with my investment? And what is the price per share?”. While this is a pretty straight-forward question to answer when dealing with stock market, it gets more complex in angel investing.
When angel investing, often times you aren’t actually investing in a stock or equity round; rather, you are investing into a convertible note. A convertible note is a unique convertible equity instrument with advantages over straight equity both for the startup and investor in early stage rounds.
By definition, convertible notes are a type of short-term debt, which earns interest, then converts to equity upon a predetermined date or milestone (usually the next financing round). Additionally, the note has a conversion price, which is usually at a discount to the valuation in the next equity round of financing. Annual interest rates on notes range from 6 to 8 percent based usually on the stage of financing for the company. Generally, most notes convert within 12 months as that is the window of cash-burn the note can cover.
So why do companies use convertible notes anyway? While there are many potential answers to that question, they all boil down to one general principle: early stage companies are hard to value, and convertible notes serve as a solid compromise between investor and startup. At the earliest stages, companies don’t want to undervalue their company and sell too much of it to investors. At the same time, investors don’t want a $25 million price tag for a business still in its infancy.
Here’s an example of how it all may work:
Ed’s Pharmaceuticals is looking to raise money for their new blood-thinner drug. The science is early stage — only minimal data and still far from meeting with the FDA — but very promising. They need to raise $2 million but can’t seem to agree on a fair valuation with their lead investors that works for both sides. So, they draw up a convertible note. The pertinent terms they will need for the note are:
- Amount to Raise: $2 million
- Interest Rate: 8% annual
- Pre-Money Valuation: $10 million
- Conversion Date: Either 12 months from the close of the note or upon the first $1 million raised in the next round of Equity Financing
- Conversion Terms
The first three points are fairly straightforward. Conversion date is a general estimation of when the company will have burned through the cash raised on the note and should be well into their next round of financing. The interest rate, as we mentioned earlier, is somewhat standard.
The conversion terms are where the note can get a bit more tricky. Usually there are two or three ways for the equity to convert that are listed in the term sheet, and the term sheet will spell out whether it converts at the higher or lowest valuation calculated by the various options. The two most common options are as follows:
- The first, and most common option, is typically the pre-money valuation plus the amount of cash raised on the note. In this example, that would be $12 million.
- Converts at a discount to the Pre-Money Valuation in the next round of equity financing. This is typically a 10-20% discount. So, the the valuation on the next round of financing is $25 million, the noteholders would convert at $20-$22.5 million.
The second option is where the fairness of a convertible note really comes into play. For example, if the company’s next valuation is at $25 million, then they don’t suffer from undervaluing the company in the first round and the conversion price is only 10-20% off from the current valuation. Additionally, for noteholders, they are seeing a 10-20% return on their investment in a 12 month or less period of time. Overall that’s a win-win for both sides. (If you’d like to see more about how investors can track growth in their angel investments, click here.)
Convertible notes comprise more than half of the investments angelMD has made to date. As notes convert into equity, I’ll be in touch with you to share the information on the stock price and number of shares you purchased through the syndicate. I’m always happy to chat with investors about their syndicate investments or about any of the other investment opportunities we have available on the website.
If you’d like to speak with me about the mechanics around early stage investing or about how you can get more involved in our investing process, please send me an email, or you can click here to schedule some time to chat over the phone.
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