Convertible Notes vs. Equity Financing: Pros and Cons for Cap Tables

Finding a source for funding is a critical stage that can change the course of a startup’s development. Choosing between convertible notes and equity financing is crucial for promising firms seeking external finance. These two dissimilar approaches have far-reaching effects on the cap table structure and the startup’s financial viability.

While these are the main factors, it’s essential to carefully consider the pros and cons of both methods of managing cap tables.

Understanding the Risks and Benefits of Convertible Notes

Convertible notes are a short-term debt instrument often used by startups to secure early-stage funding. Investors provide funds to the company with the expectation that the debt will convert into equity at a later, specified event, usually a subsequent funding round. This allows startups to delay determining their valuation until a later date. Convertible notes may carry interest and conversion terms, such as a discount or a valuation cap, that incentivize early investors for the risk they take.

Example of incentive for the convertible note investor:

A scenario is where an investor acquires $25,000 worth of convertible notes, bearing an 8% interest rate and a 20% conversion discount. Upon a qualified financing event occurring 18 months after the sale of convertible notes, the company proceeds to sell equity at $3.50 per share. At this point, the accrued interest on the notes amounts to $3,000, culminating in a total of $28,000 due to the note investor.

Leveraging the 20% discount, the conversion price for the notes equates to $2.80 per share, resulting in the investor obtaining 10,000 shares of the fresh stock. During the qualified financing event, the investor could have secured 7,143 shares if they had purchased the stock. This underscores the notable incentive for the convertible note investor who embraces the risk of early investment.

It is important to comprehend the advantages and disadvantages of convertible notes. Let’s see,

Pros in Cap Tables:

Here are some pros of convertible notes for cap tables.

• Low Initial Dilution: Convertible notes allow the startup’s valuation to be determined in a subsequent funding round, delaying the dilution of existing shareholders. By delaying the valuation, current shareholders’ stock ownership is diluted less drastically at the outset of the capitalization table.
• Deferred Valuation: With convertible notes, companies can raise capital without instantly assigning a valuation, allowing for more time to make strategic decisions. Founders may instead concentrate on improving their products and testing them in the market before dealing with value issues.
• Flexibility in Terms: Convertible notes provide a range of customization options, including discount and interest rates and valuation limitations. As a result, businesses and investors can sign agreements that satisfy everyone’s needs.

Cons in Cap Tables:

Here are some risks of convertible notes in the cap table.

• Delayed Valuation Impact: The impact on equity ownership for all parties involved is delayed because of the potential benefits of deferring valuation. Because of this haziness, investors, entrepreneurs, and workers may not be on the same page.
• Complicated Capitalization Structure: Conversion of convertible notes into stock can add complexity to the capitalization structure. Adopting different conversion rates and conditions can make managing the cap table and raising capital in the future more difficult.
• Inaccurate Equity Projections: Predicting long-term ownership percentages for stakeholders becomes difficult due to the delay of valuation. Because of this unpredictability, strategic planning and decision-making may be hampered.

Equity Financing: Direct Ownership, Transparent Evaluation

Equity financing involves raising capital for a company by selling ownership shares, or equity, to investors. This approach allows investors to become partial company owners and share in its profits and potential growth. Equity financing typically involves determining the company’s valuation, issuing shares to investors, and formalizing ownership through legal agreements

Example For Equity Financing;

Here is a simple example for Equity Financing:

Here is the equity section of an balance sheet, this company raised SAFE Notes of $7.6M in their equity financing round, the company also have both common stocks and preferred stocks as their equity (Total amount = 8265+2882+3287381 = $3,298,528).

Pros And Cons Of Equity Financing In Cap Table

Let us now understand the pros and cons of equity Financing in the cap table

Pros for Cap Tables:

Here are some advantages of Equity financing in cap table:

• Immediate Valuation: Startups seeking equity financing must have their value established immediately before the transaction. The cap table will be more accurate with an upfront appraisal.
• Clear Ownership Structure: Investors in a company with a 100% equity financing structure have 100% ownership of all of the company’s shares. This easy-to-understand ownership structure makes it far less complicated to keep track of ownership percentages and makes it easier to create an accurate cap table.
• Alignment with Long-Term Goals: Equity investors’ interests are linked with those of the company over the long run. Their vested interest in the company’s success makes them more invested in its growth and development.

Cons for Cap Tables:

There are also some disadvantages of equity financing,

• Higher Initial Dilution: Assigning an initial valuation through equity funding might result in larger initial dilution for founders and early employees. This may affect their share of ownership on the capitalization table.
• Complex Process: Equity funding requires a substantial amount of paperwork, including shareholder agreements and financial projections. Due to its intricacy, investment rounds may be stretched out, and large legal fees may be incurred.
• Rigidity in Terms: Equity financing has strict terms since the given valuation determines the exact proportion of ownership. The startup’s ability to negotiate favorable terms with investors may be hampered due to this rigidity.

How to Strike a Perfect Balance at the Cap Table

There is a fine line to walk when deciding between convertible notes and equity funding. Equity funding clarifies and aligns with long-term goals, while convertible notes provide flexibility and delay valuation. The capitalization table management heavily influences the distribution of ownership and the business’s organizational structure.

Finally, the startup’s growth strategy, investor expectations, and risk tolerance should all be considered when deciding between convertible notes and equity funding. To make a choice that lays the groundwork for cap table success, founders and investors need to carefully analyze the advantages and drawbacks within the context of their unique business experience.

Convertible Notes vs. Equity Financing — Eqvista Guides Your Financial Spectrum

Cap table management relies heavily on striking a balance between the benefits of both strategies. A startup’s growth plan, tolerance for risk, and the expectations of its investors all factor into this decision. Eqvista’s cap table management solutions pave the way for a prosperous cap table journey by allowing businesses to keep track of ownership, simulate situations, and maintain transparency.

Start your quest to cap table greatness now by contacting us now!