Even as startup funding fell by a whopping 33% in 2022, the value of convertible notes written by venture capital investors to both early and late-stage startups rose to $120 million from just $2.5 million in 2021, data from private investment tracking platform Tracxn showed.
Among the companies that raised money via convertible notes include Udaan, StrideOne, LemmeBe, Clensta and echargeup. Some of the most active investors who wrote convertible notes in the last two years include names like Microsoft, Lightspeed Venture Partners, Nomura, Beenext, Prime Venture Partners, Stellaris Venture Partners, Brand Capital and SBI.
A convertible note allows investors to lend to the startup and the option to convert the loan into equity in the future. They typically have a maturity of typically five years post which the note would be repaid or converted into equity shares.
Ankur Bansal, co-founder and director of BlackSoil observed that typically the discount on a convertible note could range between 10% and 25%. “Higher-risk investments would attract a larger discount while the ones with a lower risk may command a lower discount,” he said.
If things go well, investors can encash the shares at a better valuation. However, as Bansal pointed out, if the startup is unable to raise funds at a better valuation, investors may opt not to convert the notes into equity. In that case the convertible note would remain as debt and need to be repaid, potentially posing challenges for fragile startups.
Convertible notes offer startups a shield against down rounds especially when investors disagree with them on valuations. “The main prerequisite of raising a convertible note as opposed to traditional equity is that the business does not need to be valued immediately,” Bansal said.
As Ankit Agarwal, managing partner at venture debt firm Alteria Capital, pointed out, as the slowdown approached and startups needd capital to grow, neither the investors nor founders were willing to go for a down or flat round. As such, convertible rounds have spiked. Agarwal added that convertible notes offer a safeguard against down rounds since the shares are converted at a pre-agreed valuation and a floor price is fixed.
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“Say a startup was valued at $500 million in 2021 but the appropriate valuation could have been $300-400 million. Now, if the company needs funds, instead of agreeing to a down-round the existing investors can write a convertible note. It can use the money to run the business and negotiate a better financing round later,” Agarwal explained. He added that convertible notes cannot delay the inevitable — down rounds — but it still provides startups with a fighting chance to improve the metrics.