PS#027: The Art of the Convertible Instrument
Before we leave the topic of convertible instruments, I wanted to share some situations in which these instruments can be used by venture capitalists and founders.
If you’re just joining in, I encourage you to check out the previous issues on this subject, which cover Priced Rounds, Convertible Instruments, Convertible Notes, and SAFEs. This will give you a full picture of the most common financing structures and how they work.
For today, we’ll dive a bit deeper into the art of using these convertible instruments. Focusing on three major use cases…
Reaching a higher valuation
Securing capital allocation
Extending runway
Let’s dive into each of these in more detail.
Disagreement on valuation.
First, let’s just set the foundation.
As we’ve discussed, the main reason for convertible instruments is to temporarily align stakeholders when there is a disagreement on valuation.
The founders and investors may not be able to agree on a specific valuation, but would still like to work together. The convertible structures allow them to push this discussion down the road, when there may be more clarity around valuation.
Typically, disagreements in valuation will manifest in the following scenarios…
Pre-seed/seed companies (where SAFEs are often used)
Startups that don’t need to raise capital
Businesses nearing an inflection point
Changing market conditions
Keep these scenarios in mind as we move into the 3 different use cases mentioned above.
(1) Reaching a higher valuation.
In our first use case, providing additional capital via a convertible instrument can help a startup reach a higher valuation (than they may have otherwise).
There are certain performance metrics (i.e., revenue growth, gross margins, efficiency, etc.) that investors are looking for at each stage of venture capital investing. Whether it’s Series Seed, A, B, C, etc., each set of investors has a general view on these performance metrics, as well as their corresponding valuations.
A startup’s performance across these metrics will play a key role in determining its valuation. If they have additional capital, they can push for those better metrics and garner a higher valuation.
(2) Securing capital allocation.
In the second use case, investors may use a convertible instrument to secure allocation in a potentially competitive, future financing round.
High-performing startups may have their choice of venture capital investors.
Investors can use a convertible instrument (whether it be a SAFE or convertible note) to provide a smaller infusion of capital well ahead of a priced round. The instrument will eventually convert into equity as defined by the valuation cap and/or discount, which could potentially lead to more favorable terms for the investors.
For the founders, they can use this capital to increase their negotiating leverage in a priced round, pushback a fundraise, or run after a higher valuation (as we discussed above).
(3) Extending runway.
The third and final use case we’ll discuss today involves using a convertible instrument to extend the cash runway for a startup.
This is more often a move used by existing investors to provide support to their portfolio companies, but can also be done by new investors (often called an “extension” in this scenario).
The growth journey for a startup is not always smooth or straightforward. There’s almost always a few (if not a lot) of bumps along the way. Sometimes, it may take a startup a bit longer to figure it out, requiring additional capital.
Convertible instruments are a good way to provide this additional capital.
Investors can be protected by a preference (in the case of a convertible note), valuation cap and/or discount rate, and founders can use the additional capital to improve the company’s performance/position.
Alright, that’s it – three use cases for using convertible instruments and a little more of the art behind structuring venture capital investments.
