Equity vs. Convertible Notes: Choosing the Right Fundraising Strategy for Your Startup
Written By Haley Kopp
You’ve decided that you want to scale your company. Typically, quick growth of a company requires an outside investor to provide the company with an influx of cash. This makes the task of raising capital one of the most critical
decisions for any startup founder.
The way you structure your fundraising can have lasting implications on ownership, control, and future financing rounds. Two of the most common early-stage funding options are selling equity and issuing convertible notes. Each approach comes with its own advantages and trade-offs. Here’s what
to consider when deciding between them.
Equity Financing
Equity financing involves selling shares of your company to investors in exchange for capital. Investors receive a direct ownership stake and typically gain certain rights, such as voting power and board representation.
Pros of Equity Financing:
No Debt Obligation: Unlike loans or convertible notes, equity financing does not create an obligation to repay investors.
Aligned Incentives: Investors share in the long-term success of the company, making them more inclined to provide support and guidance.
No Maturity Date: There is no looming deadline for conversion or repayment, which can alleviate financial pressure.
Cons of Equity Financing:
Dilution of Ownership: Selling shares will reduce the founder’s ownership stake, which can impact control over the company.
Complex and Costly: The process of raising equity financing requires legal agreements, negotiations, and often, a longer timeline.
Difficult to Value an Early-Stage Company: Valuing a startup in its early stages can be challenging, potentially leading to undervaluation.
Convertible Notes
A convertible note is a form of short-term debt that converts into equity at a later financing round. Instead of setting a valuation upfront, investors provide capital in exchange for the right to receive equity at a discount when the startup raises its next round.
Pros of Convertible Notes:
Faster and Less Expensive: Convertible notes involve less
negotiation and fewer legal complexities, allowing startups to raise capital more quickly and affordably.Delays Valuation Debate: By postponing valuation until a future funding round, founders can raise money without immediately defining their company’s worth.
Investor Incentives: Most convertible notes include a discount or valuation cap, rewarding early investors with a favorable conversion rate.
Cons of Convertible Notes:
Debt Obligation: Until conversion, a convertible note remains debt on the company’s balance sheet, which may pose risks if the company does not raise a follow-up round.
Uncertain Future Dilution: The eventual equity dilution is unknown until the note converts, which can create challenges in long-term planning.
Maturity Deadlines: If the startup does not raise another round before the note matures, it may need to repay investors or renegotiate terms.
Which Option Is Right for Your Startup?
The choice between equity and convertible notes depends on your startup’s stage, fundraising goals, and investor preferences. Here are a few guiding questions to help you decide:
Do you have a clear idea of your company’s valuation? If not, a convertible note might be a better option to delay valuation until more traction is gained.
Do you want to close the round quickly and with minimal legal costs? Convertible notes are generally more efficient in this regard.
Are you comfortable with potential debt obligations and
maturity deadlines? If not, equity financing may be the safer choice.Are your investors open to convertible notes? Some investors prefer direct equity ownership, while others are comfortable with convertible instruments.
Conclusion
Both equity financing and convertible notes offer unique benefits and challenges. Understanding these trade-offs can help you make an informed decision that aligns with your company’s growth strategy and financial needs. Whether you choose equity or convertible notes, working with experienced legal and financial advisors can ensure a smooth fundraising
process and set your startup up for long-term success.
Adam Yohanan is a transactional business lawyer with extensive experience representing companies, investors, and entrepreneurs in a wide range of high stakes business transactions.
Adam handles the small and large transactions in the life of a businesses, including mergers & acquisitions, entity formations, partnerships and joint ventures, investing and fundraising, commercial contracts, and dissolutions. His office can be reached at 212-859-5041.
Haley Kopp is a corporate lawyer focused on representing start-ups and small companies in formations, venture capital, angel investor financings, mergers and acquisitions, and general corporate matters.
Haley's diverse experience gives her a practical approach to solving complex business issues, whether guiding companies through financing rounds or corporate transactions. Her office can be reached at (619) 512-3652.
This guide is meant for educational and informational purposes only and should not be considered legal advice. It is essential to consult with an attorney or other advisors regarding all legal and other important matters.
