In the ever-expanding world of available funding opportunities for startups, convertible notes have emerged in the last few years as a popular alternative to debt equity. As a traditional option, more entrepreneurs are familiar with debt equity but are not sure which one may be right for them.
Here are some of the pros and cons of each option.
Convertible Note
A convertible note --- sometimes called a bridge loan because it bridges the funding gap between startup financing and A or B rounds of funding --- is structured like a short-term loan. It sometimes includes discounts or caps to compensate the angel investor or early stage venture capital firm for taking somewhat of a risk by coming on board at the seed stage.
The outstanding balance of this loan can then be converted to equity at a later date when a startup has reached a particular milestone and is ready to receive valuation. As investor Seth Levine noted in his blog on post convertible notes, "Both these terms are designed to bound the risk that the convertible debt investors are taking in not pricing the round - they're investing in a debt-like instrument with equity like risks."
A convertible note is particularly beneficial for those startups that want to tap into funding at an early stage to develop the business but cannot get in front of those investors that prefer to come in at a later stage where the company is built out further.
Other advantages include it is considered to be a simple, cost-effective, and quick way to tap into funding. The quick part is the fact that a convertible noted can be closed in a matter of a couple of days and requires minimum legal fees to prepare.
There are also no complex terms involved, which helps the startup get the money and go forward with building rather than spending time on the tricky world of negotiation and valuation. In fact, by skipping out on the valuation process at this point with any investors, a startup does not have to contend with dilution, tax, and control issues.
One thing to remember is that a convertible note is like any type of loan: it will need to be repaid at some point in the future, and that includes whether or not a startup does get another round of funding in the future to make that repayment. Even with no other funding rounds, that note will come due. That is why convertible notes are often much smaller in size.
Also, don't expect those investors to participate in anything related to operations. That can be a good or a bad thing, depending on what you need from an investor.
This is strictly considered a loan that does not deliver any type of incentive for the investor to help you build out your startup. Of course, you may prefer that lack of participation.
Debt Equity
However, it can be said that faster and cheaper is not always the best route to funding a startup. There are many types of debt equity vehicles available today, including online peer-to-peer lending platforms, bank loans, and working capital along with credit cards, revolving lines of credit, and loans from family and friends, which may be almost as fast and cheap but offer a few more advantages over convertible notes.
While some of the advantages and disadvantages vary slightly for these debt equity vehicles, there are some overriding advantages and disadvantages to consider.
Most debt equity vehicles allow you to get your hands on capital fairly quickly. Typically, bank loans take the longest but others can be within the same day or a few days. Some debt equity vehicles like peer-to-peer lending come with very few fees (less than a traditional bank loan). The terms vary but usually remain straightforward although some may require proof of collateral that would have to be surrendered should you default on a loan.
Many of these debt equity vehicles provide an amount that you may or may not use, which also offers additional flexibility as you continue to develop your startup. Having it there if you need it may save you from having to seek out additional funding sources as you build momentum and scale up.
Additionally, there are varied lengths of time and different interest rate schedules that are available, giving you much-needed flexibility that suits your startup's timeline. Another advantage (or potential disadvantage, as noted with the convertible note) is that there tends to be no or very little involvement from the debt equity funding source in your startup's strategic direction and daily operations. Some, such as a bank, might want to know specifically how you plan to spend the money but not much beyond that level of involvement.
One of the primary disadvantages is that if you already have bad credit as an individual, your startup may be adversely impacted by this tarnished history and you may not be able to access any debt equity vehicles or have to pay much higher interest rates and/or receive restricted amounts of funding. If you pursue a bank loan, you may be required to agree to a personal guarantee should your startup fail, making you personally liable for loan repayment.
Final Thoughts
The answer to the question of debt equity or convertible note really comes down to what you need and what you feel comfortable taking on in terms of loan size, repayment schedule, and requirements and restrictions involved with each type of debt.
As a startup founder, you will need to sit down and thoughtfully consider the most prudent lending sources based on how long you plan to take to start developing the revenue streams you need to begin the repayment process. You want to sustain your startup while not tarnishing your credit history and reputation.