Convertible rounds: when and how to raise one.

Convertible rounds are a great tool in the arsenal of a start-up founder. When raising a straight equity round you need to assign a valuation to your company – a very tricky subject (especially in the current environment) that I tackle on this post. This is something that you would need to do in a straight equity round (including crowdfunding rounds).

At the time of writing (late April ’20), there’s a reported downwards pressure due to the current pandemic on the start-up valuations, especially affecting later rounds (it’s perhaps too early to see the effect on seed rounds). Convertible rounds might be a great way to cash in the funds you’ve secured and extend your company runway.

The benefits of convertible rounds

With a convertible round, you can raise capital without issuing shares. There are two main typse of convertible rounds

1. An Advanced Subscription Agreement: the investor puts the money in now and converts it into shares on the next funding round, typically with a discount. The good news is that for UK based companies, they will still be eligible for SEIS/EIS tax relief, provided you close the round within 6 months.
2. A Convertible Note: is a form of short-term debt that converts into shares at a later date, typically with interest and at a discount. This form of funding is not eligible for SEIS/EIS.

The main benefits of such rounds are:

• As we’ve discussed, you don’t need to issue shares.
• They can be quicker than a full equity round, enabling you to lock in committed investment.
• We’ve also discussed how you don’t need to come up with a company valuation. This has the potential to avoid thorny issues of down-rounds in the future.
• They might allow you to get funding without a cornerstone investor (i.e. someone leading the round).

Metrics of convertible rounds

With so many funding rounds under their belt, SeedLegals has been able to analyse the average convertible round (Advanced Subscription Round) in the UK. They have all the metrics on the linked article, but summarising:

• Discount: convertible rounds typically offer between 10% and 20% discount vs. the price on the next funding round.
• For Convertible Notes, you would also have the interest rate. Rather than be repaid in cash, this would increase the number of shares the investor would receive. They are typically 4-6%.
• Valuation cap: is the maximum valuation at which the investment will convert. This protects your investors in case you’re doing exceptionally well.
• Low valuation: it’s the minimum that the shares will convert to. Typically the ratio cap/low valuation is around 2x
• Longstop date: when the round would be converted into equity. Typically 12 to 18 months from the date of closing the convertible round (or 6 months if you want your company to be eligible for SEIS/EIS in the case of an Advanced Subscription Agreement).

Different platforms to execute your convertible rounds

If you’d like to execute your convertible round online (which I would recommend for time efficiency and costs), you have a couple of options:

• Equity Crowdfunding platforms: Seedrs and Crowdcube both offer Advanced Subscription Agreements. The benefit here is that you’ll be able to use the Nominee for future rounds and engage effectively with a big base of investors in the future.
• SeedLegals: Offers both types of convertible rounds. For a small number of investors, it will represent lower costs and the additional benefit to access all the other legal services they offer.

How to go about your convertible round

My heuristics to raise money with a convertible round would be the following:

1. Do your investors require SEIS/EIS? Are you confident you’ll close the bigger round in 6 months? If you’ve answered yes to both, go for an Advanced Subscription Agreement with a 6 months longstop date. If not, you might consider a Convertible Note.
2. Do you have a big base of customers that can potentially convert into investors? If yes, I would consider crowdfunding with either Seedrs or Crowdcube.
3. Do you have a small group of investors (perhaps from the 3Fs or Angel Investors) ready to go and want to accelerate the process? Then I would choose SeedLegals.

Wrapping it up

Convertible rounds can be a great tool in these times of uncertainty. Feel free to ask and comment on the topic. And if you need help on this or on any other start-up funding topic, don’t hesitate to contact me.