Technology and life science companies often have aggressive growth strategies centered on scalable software or products. To achieve their ambitious goals, these companies typically require multiple rounds of investment capital, sourced from friends and family, angel investors and venture capital firms. Each funding milestone can be time-consuming, involve extensive negotiations and incur significant legal expenses.
The costs and delays associated with these funding rounds can slow a company’s momentum. Convertible securities — such as convertible notes and Simple Agreements for Future Equity (SAFEs) — offer a faster method for raising capital while the next funding round is being negotiated. These instruments also provide management with valuable time to meet specific performance metrics, identify the ideal equity investor and clearly define the company’s future strategic goals, which can enhance its overall value. Put simply, convertible securities can provide a “bridge loan” to help address short-term cash flow needs between capital raises.
Given the favorable and unique terms these securities typically offer to the debtor/investor, it is essential for your tech company to fully understand their mechanics, implications and accounting considerations.
A convertible note is a debt instrument that can convert into equity (shares) of the company at maturity or upon a defined triggering event — typically the next capital raise. Similar to conventional debt instruments, convertible notes may include an interest rate, a maturity date and other standard terms. However, they often feature additional provisions, such as a “conversion discount.” This discount allows the debtor/investor to convert their debt into equity at a price lower than that paid by other investors in the same round.
For example, consider the issuance of a convertible note for $100 with a 12% interest rate and a 20% conversion discount. After one year, during a funding round where equity is priced at $1 per share, the note would convert into $112 worth of equity ($100 principal plus $12 in accrued interest). However, due to the 20% discount, the conversion price would be $0.80 per share ($1 per share minus 20%). Consequently, the convertible note holder would receive 140 shares ($112 ÷ $0.80 per share), while other investors in the round would only receive 112 shares for the same $112 investment.
This example underscores the importance for companies to evaluate the trade-off between receiving immediate capital and the potential equity dilution that may arise in the future.
SAFEs have gained popularity as an alternative to convertible notes, particularly among start-ups seeking to raise capital quickly. Unlike convertible notes, SAFEs do not carry an interest rate or other typical terms in a debt instrument. Instead, SAFEs convert into equity at the next capital raise, typically under terms favorable to the investor. Similar to convertible notes, SAFEs may feature conversion discounts or other provisions that influence the amount of equity units issued upon conversion.
For example, if a SAFE for $100 is issued with a 20% discount, and the next equity round is priced at $1 per share, the SAFE holder would receive 125 shares ($100 ÷ [100% - 20%]). Additional terms commonly associated with SAFEs, including valuation caps and distinctions between pre-money and post-money valuations, may impact the final number of shares issued under the agreement.
Convertible securities can be particularly advantageous for technology and life science companies, especially start-ups. However, it is crucial to carefully assess the long-term implications these instruments may have on your company’s ownership structure. Specifically, be mindful of the potential for unintended dilution of ownership among existing investors. Furthermore, the existence of convertible securities can influence the terms of future funding rounds, including the amount of capital you can raise and the price at which you can raise it.
In addition to strategic considerations, understanding the accounting treatment of convertible securities is essential. Accounting for these instruments under Generally Accepted Accounting Principles (GAAP) can be complex, and a thorough understanding of the underlying terms is necessary for accurate classification and valuation. Recent updates to GAAP, including Accounting Standards Update (ASU) 2020-06, have simplified the accounting for convertible debt; however, you still must exercise caution when valuing and classifying these securities.
Contact Brian Fiedler or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.