One of the most popular ways of investing in high-growth startups is via convertible securities.
At their simplest, convertible notes allow investors to invest cash into a company immediately, but the shares aren’t priced or issued by the company until further down the road – usually triggered by an external event, such as a Series A funding round.
The traditional Silicon Valley convertible takes the form of convertible debt. Here at Seedrs, we’ve developed a new financial instrument, convertible equity, which serves a similar function but differs in two key respects: first, there is no interest payable; and second, the initial investment cannot be repaid, therefore must convert to equity by the agreed date.
There are obvious benefits to entrepreneurs using convertibles to secure early stage investment. Sometimes, it just isn’t the right time to pin down a precise valuation for their business. They may be lining up an institutional investor for a future funding round, but are seeking bridge funding that won’t prejudice valuation negotiations.
But while the benefits of a convertible structure for startups are plain, the benefits for investors are slightly less obvious.
First, a convertible structure means you get the comfort of a valuation that has been negotiated and agreed by a large investor, with the added benefit of a discount on shares when the note converts.
And second, there are tax benefits. The Seedrs structure of convertible equity instruments means investments can be are eligible for generous income tax reliefs under Enterprise Investment Scheme (EIS). EIS investments attract 30 per cent relief, Seed EIS investments attract 50 per cent relief.
Early-stage equity is also eligible for loss relief and is exempt from inheritance and capital gains taxes. For people who have maxed out their Isa, or are subject to the new pension allowance taper, EIS and SEIS can be particularly attractive options.
A recent Seedrs case study illustrates just how attractive investment in convertible equity can be. SellMyLivestock is an agritech company that operates a grain and livestock marketplace for UK farmers. Its first fundraise was an equity campaign that closed in November 2015. Following strong growth across key metrics, it decided to do a convertible equity campaign in late 2016.
Growth continued into 2017, and in the past few weeks the firm secured a follow on funding round of £500,000 at a £5m pre-money valuation, which triggered the conversion of the convertible equity investment into shares.
The discount rate was set at 20 per cent. However, due to the significant growth of the business, the valuation of the latest funding round exceeded the valuation cap.
As a result, investors in the convertible were issued shares at a price discounted by 39 per cent on conversion, representing a near doubling in paper value within less than a year – and that’s before taking account of tax reliefs. Now that the shares have been issued, eligible investors will be able to claim 30 per cent of their investment back via EIS relief.
Convertible fundraises need to be fully subscribed on a platform, so investors still benefit from the wisdom of the crowd.
Ultimately, the discount is compensation for investors who are investing in a company without knowing how much of the business they are buying. But for investors who can stomach that risk, the reward can be handsome indeed.