• Monday, July 22, 2024
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Breaking the impasse: Unlocking early-stage funding with convertible securities

Innovate Africa backs early-stage startups with $2.5m investment

Perchstone & Graeys

The frustrating question of “Who else is investing?” can stall startup funding. From the investor’s perspective, it’s a waiting game to see who jumps first, as though the presence of another investor validates the investment’s soundness. However, this mindset has proven unreliable, as illustrated by the Theranos debacle.

The cautious investor is not wrong to hesitate. Investing in the early stages of a company is inherently risky, with the Wall Street Journal reporting that 3 out of 4 startups fail. The lack of transaction history and valuation makes it challenging for investors to gauge both the business’s viability and the extent of their equity in the company. For some investors, the dreaded question is not about deferring their judgment to others; rather, it is about the ability of the founder to persuade their inner circle (friends and family) to believe in the venture and commit their money. Despite this, the question often creates a frustrating impasse between startups and investors.

Breaking the Impasse

How can this impasse be broken? – The solution often lies in rewarding the daring investor. Such rewards, along with streamlined processes and reduced costs, simplify and accelerate investors’ decision-making. These qualities are embodied in convertible securities.

Understanding Convertible Securities

Convertible securities allow companies to raise funds from investors with the promise of converting the investment into equity upon a triggering event. The most common event is a ‘priced financing round,’ when the company issues priced shares to new investors.

While holders of convertible securities do not immediately receive shares, they benefit from converting their investment at the lower of the company’s valuation cap or a discounted price per share. By capping the valuation, parties peg the company’s maximum value at a certain amount, regardless of a higher future valuation. This ensures that the holders’ shares convert at a lower valuation, providing them with more value compared to new investors.
Alternatively, holders can opt for a discounted price per share, meaning they purchase shares at a discount during conversion. This flexibility allows holders to choose the option that offers the best deal. However, issuing shares at a discount in Nigeria is unlawful, making the valuation cap particularly useful.

SAFE and Convertible Notes

Convertible securities include convertible notes and SAFE (Simple Agreement for Future Equity). While both delay valuation and conversion to equity, they differ significantly. Unlike SAFE—which is simply an investment from the investor to the company—convertible notes are loans with a maturity date and interest rate. The presence of interest increases the investment’s value at the time of conversion, unlike in SAFE where the invested amount remains unchanged. Convertible notes also rank higher than SAFE, meaning that in case of the startup’s failure, convertible note holders are paid before SAFE holders. Thus, while SAFE favors founders, investors prefer convertible notes for the security they offer.

Convertible Securities as the Deal Maker

Although convertible securities do not eliminate the risks associated with early-stage funding, their value lies in their rewards, flexibility, and simplicity, leading to quick deal resolutions. Startups and investors can focus on the essential elements: amount, interest, and maturity date (for convertible notes), valuation cap, and conversion triggers. SAFE is even simpler than convertible notes, as parties only need to discuss the investment amount and valuation cap. Additionally, since valuation and share issuance are deferred, both the company and investor save money and time that would otherwise be spent on valuation, advisors, and negotiating equity terms. This simplicity encourages swift deal closures.

Ugochukwu Obi, Partner at Perchstone & Graeys

Omolade Afonja, Intermediate Associate at Perchstone & Graeys