Q&A: Understanding Convertible Notes, Reg. CF and Reg. A+ Raises

Editor’s Note: Welcome to the Early Investing Mailbag. Each week, we answer questions we think will help you learn about investing in pre-IPO startups and cryptocurrencies. If you have any questions for us, please email us at mailbag@earlyinvesting.com. Just remember, we can only answer your general questions for information and strategy. We can’t offer personal advice.

Q: When investing in startups, what’s the difference between buying shares vs. a convertible note?

A: When we invest in early-stage startup companies, we’re often investing in what’s called a “convertible note.” Technically, it’s short-term debt that will convert into preferred equity (stock) at a later time.

Convertible notes are useful when it’s hard to pin down an exact value for a company. The valuation will be decided down the road, but as an investor you get locked-in “caps” and “discounts” on your shares, if and when they convert.

These instruments have become standard in a majority of early-stage (seed) funding deals. Most equity crowdfunding deals use convertible notes (or something very similar).

It sounds complicated, but it’s really not. In essence, you’re making a bet on a startup that gives you very high upside if the company does well. If the company fails, which does happen in early-stage investing, the note will likely never convert into shares (but the shares would have been worthless anyway).

There are a lot of ways to structure a convertible note, so let’s dig a bit further. Here’s an example of how these notes work.

Acme.io is a make-believe startup selling software. The company’s early product looks good, and it has a small group of dedicated customers. Acme.io is doing only about $15,000 in monthly revenue, but it’s growing by 40% month over month. That kind of growth can compound quickly, so investors agree to fund the company using a convertible note that has the following terms:

  • Valuation cap of $5 million: This is the highest valuation your note will convert into shares at. If the company is valued at more than $5 million in its next funding round, you get shares at the “capped” level ($5 million). So if the valuation of the next round is $10 million, you essentially get a 50% discount on your shares for investing early.
  • Discount of 20%: Let’s say the startup does pretty well over the next six months, and it does a Series A funding round at a $5 million valuation. You get a 20% discount on the valuation because you took a risk early.
  • Interest rate of 4%: Some convertibles pay a small interest rate as a deal “sweetener.” However, since most startups don’t have much cash flow, this isn’t something I generally take into account when deciding whether or not to invest. If the startup succeeds or fails, the 4% interest won’t mean much either way. This is the least important term.

The alternative to a convertible note is a “priced round.” Here, investors and founders agree to value the company at a specific dollar amount. For example, if a startup raises money at a $4 million “pre-money” valuation and then takes on $1 million of funding, the company’s “post-money” valuation is $5 million. However, this is more appropriate for mature startups that have steady revenue and growth. For early-stage seed deals, the convertible note remains the most popular option.

+ Early Investing Co-Founder Adam Sharp

Q: Hi, boss. I love your recommendations. But I’m trying to figure out the difference between these different types of raises. Some are under Regulation CF, the CF standing for “Crowdfunding,” right? Others are under Reg. A+. I know that that the CF regulations have lower maximum amounts you can raise, $1.07 million vs. $20 million under A+. Is that the only difference? As an investor, what do I need to know about how CF and A+ differ? And, please, keep it short. Long answers hurt my head.

A: OK, here’s the short version. I’m keeping it under 5,000 words… just for you. You got the basics: Reg. A+ allows startups to raise more – up to $50 million, though most companies choose the $20 million option. Why?

It’s cheaper and easier. With the $20 million option, a startup’s financials are reviewed, not audited. That means companies can avoid the semi-annual and annual financial reports required for the $50 million option. And, importantly, it bypasses having to get state-by-state approval (to raise money).

The cherry on top is that the $20 million option comes with NO restrictions/limits on how much money individual investors can contribute – unlike the $50 million Reg. A+ option and the Reg. CF option.

From an investor’s perspective, the most important thing to know is that raises under Reg. CF usually occur at the seed stage. Reg. A+ raises usually happen later – at the Series A stage, where more money is needed to fund company initiatives. (By the way, it’s just a coincidence that they have the letter “A” in common.)

One more key thing to remember here… you can find Reg. CF deals ONLY on the internet. By law, an internet portal is the required intermediary. We find our Reg. CF deals on a multitude of portals we check daily, including SeedInvest, Republic, MicroVentures, Wefunder, Netcapital, StartEngine and others.

Reg. A+ deals don’t have this requirement. But most Reg. A+ deals still seek out crowdfunding portals like Republic and SeedInvest to list on. It’s more convenient, and these portals also have their own communities of investors who check out their sites on a regular basis. So there’s built-in exposure for companies going this route.

Recently, Adam and I have noticed some companies doing Reg. A+ raises have turned around and almost immediately moved to the initial public offering phase. Investors should welcome this move. It allows them to cash out their shares, if they wish. Of course, if they think their shares will continue climbing, they may choose to hold on to them.

And that’s all I got for you… in a mere 4,999 words.

+ Early Investing Co-Founder Andy Gordon