Startup Finance: Equity Or Convertible Notes?

• Published date: 02 April 2024
• Subject Matter: Finance and Banking, Corporate/Commercial Law, Capital Adequacy/BASEL, Corporate and Company Law
• Law Firm: SimmonsCooper Partners
• Author: John Ojelabi and Chinelo Obiekwe

Introduction to Startup Finance

In the fast-paced world of Nigerian startups, securing financial support is a critical step toward growth. Many startups in Nigeria face the challenge of finding enough financial support to overcome the initial obstacles of survival and growth. With so many opportunities available, it is important for businesses to choose the financing method that best fits their business goals. This article focuses on two financing options: Convertible Notes and Equity Financing, providing founders and investors with the insights needed to navigate their choices effectively.

Convertible Notes Explained

A Convertible Note represents a unique financing instrument in the startup landscape, functioning as a loan that transforms into equity during a subsequent funding round. This approach differs from regular loans, as investors initially forego immediate returns, looking forward to becoming equity holders in the business. Convertible notes are attractive for early investors due to features like a "discount rate," allowing them to convert their loan to equity at a more favorable price than future investors.

Advantages of Convertible Notes

1. Flexibility and Control: Startups can strategically plan their shareholder structure, converting debt to equity when it suits them best.
2. Cost and Time Efficiency: Setting up convertible loans is generally quicker and less expensive than equity financing, minimizing legal and administrative costs.
3. Benefit from Interest Accrual: The equity that investors receive can increase over time as interest accrues especially if fundraising takes longer than expected.
4. Postponing Valuation: Early-stage startups can raise funds without setting a firm valuation, a significant advantage when the business's value is not yet clear.
5. Attracting Investors: The potential for a discount on equity conversion makes convertible notes appealing to early investors, offering them a better deal on future equity.
6. Simplified Paperwork: Without the need for immediate company valuation, documentation is streamlined, allowing for quicker funding rounds.
7. Aligning Interests: The conversion feature aligns founders and investors towards the company's success creating a shared incentive for growth.
8. Early-Stage Capital Access: Convertible notes offer a vital lifeline for startups not ready for a formal valuation, enabling them to secure the funding needed to launch.

Drawbacks of Convertible Notes

1. Risk of Repayment: Without further funding...