When offering convertible debt, the investor accepts the valuation at the next round of investments (in this case series A).
The risk for the convertible debt investor is that this valuation will be very high and the series A can take a long time.
To limit this risk convertible debt investors negotiate valuation caps and discounts.
Cap: The convertible debt gets converted at min=[series A valuation, cap].
Discount: The convertible debt gets converted at series A valuation * (1- discount)
(Obviously, when both cap and discount apply, the valuation for conversion becomes min = [series A valuation * (1 - discount), cap].)
Can somebody give me an advice. We have a two person startup, that is making about 20k/mo and it's growing. I am the founder. The thing is, I do not currently plan to raise VC money. My goal is to achieve revenue of 200k/mo by 2013. It is very realistic, but the problem is that as the service grows, we spend more and more time on operations, since certain things were not timely automated. We need about 300k , so that we can hire a couple of contractors to automate operations, to accelerate product development.
But since I do not plan to raise a VC round, the convertible loan would not work. What is the right mechanism for this investment? I also believe the risk is lower than normal, since we have been making money for a while, and this should be reflected in the terms and in the valuation. Is this the domain of angels to make such an investment?
FYI: Last time I stopped at the bank where I opened business checking account 2+ years ago (Wells Fargo), they sat me down and offered a 100K line of credit (the interest rate was unknown unless I applied, but she said it would be around 7-8%). The service is poorly monetized ( disproportionately high hosting fees + new hardware expenses / revenue). Until recently I was putting all these hosting related expenses on a single US Bank credit card (and paying it off monthly). In response, they raised the credit line to 40k at 8% yearly interest. This is less however than the 300k, that I think is needed. Additionally, I would prefer to use this kind bank debt financing only in an emergency, because I suppose that unlike a savvy investor, Wells Fargo and US Bank would be absolutely inflexible if I say need slightly more time, and would drive the company into default by their blanket policy, regardless of the specific circumstances.
Not unless you're willing to put up (say) your house against it. If I were a bank I wouldn't be willing to take the risk that your business will go under before it ever pays back the $300K.
Basically you need a small-scale VC or large-scale angel investment... or else to continue to bootstrap.
You can still accept a convertible debt investment.
If you don't do a series A the valuation of the sale of the company will be taken. A sale without investments in between would mean a debt investor only gets his money back + interest.
Given your situation, the debt investor might negotiate a time limit for the conversion (and either a cap or a formula for the valuation at that point).
Speaking as someone who's automating a large-ish business right now: 300k will buy you a lot of contracting. It might be possible to do what you want for less, which would expand your options.
Email me, and I'd be happy to discuss your situation and provide pointers where I can. (address is in profile)
I would seek out 2-3 angels who can provide the $300k investment. It's going to be (near) impossible to get a $300k loan on $20k/month gross revenue. Definitely not something any reputable bank will put forth in these times.
You'll likely need to part with 10-20% equity in the business, but the value of the $300k to take you to the next level should make sense. Think of it as - can we get to $200k/m by 2012 if we have $300k/$600k/$1mm. If you can 10x your revenue in a year and give up 20%, you're in a good place.
You may want to look into royalty/revenue based financing. I don't know if your revenue is where it needs to be for that (i.e. revenueloan.com's typical investment makes $1-5MM in revenue), but something to look in to.
Hey, my email is in my profile. I'm obviously unaware of the details but $300k to "tidy up operations" seems to be a pretty large budget. I feel reasonably confident I'd be able to help you out (ie. providing such services) for less than that.
You could try outsourcing and/or hiring students, but I suspect that the quality of outsourcing available to the average individual or startup has decreased as a result of the publishing of books like 4HWW and The World is Flat.
Quick answer - he does get equity at the next funding round. What he gets is the amount of equity that $150,000 would buy at that valuation.
So if someone else invests $250,000 for 25%, that's a valuation of $1m. Yuri would get 15% at that valuation. He'd get 7.5% at a $2m valuation and so forth.
What happens if there is no exit or "liquidity event", but the startup is profitable and never takes additional funding? When does the $150K become equity?
Some notes have automatic conversion at a given valuation (usually the 'floor', which in this case does not exist.) Others have no such clause, presumably under the incorrect assumption that a "liquidity event" will always happen if there is a success. I've dealt with both types of notes before and always insisted on adding an automatic conversion clause.
Might there also be some far-out repayment date — say 10 years — and a small interest rate (even without a discount)? Then, if the company becomes a perpetually profitable independent growing concern the loan is still eventually repaid, though not with the kind of equity conversion and appreciation the investor is really hoping for.
"Startup fails" is the reason why these companies have the so-called "limited liability". They file for bankruptcy, founders get on with their lifes, investors see nothing. This is, in fact the vast majority of the cases, and the reason investing is called "high-risk, high reward".
I understand what a debt is, so how is "no cap and no discount debt" different from a regular debt?
Also why would you as a startup would want to take a debt?
Another question - what's the point of Yuri giving the debt, it seems he's not even asking for equity in return?