The convertible bond: definition
Convertible bonds are a common form of external financing used by startups. They are a kind of short-term financing that is typically used to bridge the gap between early financing and later rounds of venture capital funding. This type of financing allows the company to obtain financing by delaying discussions on the valuation of the company's shares.
It allows startups to raise funds quickly and easily, without having to go through a lengthy negotiation process. For the investor, it is a sort of first risky bet.
How and why should you find finance via convertible debt?
Convertible bonds work in a relatively simple way. The startup issues the bond in exchange for investors' money. The bond has an interest rate, a maturity date and conversion conditions (including a discount on the future valuation of the company). The interest rate is usually low because the investor takes a higher risk by investing in a start-up. The maturity date is the date on which the bond becomes due, at which time it can be converted into shares or redeemed in full. Finally, the conversion terms define the percentage of principal the investor will receive if he or she decides to convert the bond at a later date.
Benefits and risks of convertible bonds
Convertible bonds can be an attractive option for investors seeking high-risk, high-yield investments. They also provide startups with a quick and easy way to raise funds without having to address the valuation aspect first. However, convertible bonds have some drawbacks that should be considered before using this type of financing.
First of all, convertible bonds can be quite expensive for startups, as they have to pay interest on the capital borrowed; this interest is often higher than in the case of traditional debt. Secondly, given that these bonds are short-term financing options, startups may need to refinance or seek additional funding before the maturity date, thus starting a new fundraising process. Finally, because the terms of convertible bonds are often vague or open-ended, investors and startups may be vulnerable if there is a disagreement or unforeseen event.
Overall, convertible bonds can be a great way for startups to raise money while avoiding arduous negotiations and discussions with investors. However, it is important to understand the risks and benefits associated with this type of financing before using it. As with any investment decision, it is important to do thorough research and carefully assess all options before deciding whether or not convertible bonds are the best option.
Putting it into practice: an example in numbers
Paul and Eric raise their first funds from their first investor, Jeanne, by issuing a €500,000 convertible bond with a 5% interest rate and a 20% discount. Thanks to this money, their company grows, and one year later, they plan to expand internationally. At this point, Paul and Eric still own 100% of the company.
To finance their development, they manage to attract a new investor, Marc, who is willing to invest €1,000,000 in capital in a round of financing that values the company at €5,000,000. After Marc's investment, the company is worth €6,000,000 and Marc now owns 17% of it (€1M/€6M).
When this new financing is closed, Jeanne's convertible bond is called (converted into capital). As a reward for believing in the company right from the beginning, Jeanne benefited from the 20% discount (the discount is usually between 10% and 25%). The valuation of the company for Jeanne was then €4,000,000 (€5,000,000 - 20%). The conversion of her €500,000 bond means that she now owns 11% of the company (€500K/€4.5M).
In addition, Jeanne earned €25,000 in interest (5% interest rate on €500,000).
Finally, Paul and Eric now own 72% of the company.