Convertible debt, also known as convertible notes, is a loan or debt obligation from an investor paid with equity or stocks in a company. It allows businesses to get that starting capital needed based on a company's future success. Join Jeff Smith in this episode to learn how you can use convertible debt as a great way to get started and raise that first round of capital from friends and family.
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Financing Using Convertible Debt
In this episode, I talk about convertible note financing and how incorporating as a Delaware C corp, and then raising your first round of financing using convertible debt is a great way to get started and raise that first round of capital from friends and family. I hope you enjoy the episode.
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Our topic is very important for all new founders looking to raise their first round of seed capital. It's important to note that the amount of capital necessary to raise in the convertible note doesn't necessarily have to be defined because this is your first money. For purposes of this discussion, let's assume the first dollar up to a million dollars is all going to be raised in your convertible note.
I want to start by saying to do a convertible note financing, it's important to have proper legal advice, and to incorporate as a Delaware C corp is also important to have legal advice and much of this can be researched online to reduce the budget but I highly recommend using a law firm that specializes in startups, specifically in med-tech and healthcare.
I will unpack this first. The purpose of a corporation is to create a new legal entity independent of your personal assets. There are several features of a corporation but for the purposes of this discussion, a Delaware C corp is a type of legal entity to tee of a corporation. Many companies incorporate in the State of Delaware because they have laws that are business-friendly.
The choice of choosing a Limited Liability Corporation, also known as an LLC, a C corp, or an S corp is a decision that more educated and smarter people could expound upon. With the advice I've gotten over and over, I could answer more questions on this and possibly a coaching session but suffice to say the C corp is the best entity to choose for a number of reasons. Specifically, as the company develops and takes on additional capital and if it is interested in raising capital from institutional investors, such as a venture capital firm or a private equity firm. This structure of a Delaware C corp is the most friendly for raising that capital.
Step one, create a Delaware C corporation. The relative cost of starting a Delaware C corp is going to be between $1,000 to $10,000. There are standard template documents for how to do this around board governance, the number of shares outstanding, and a service like legal is probably sufficient early on. I would recommend that building a relationship with a law firm, specializing in healthcare and med-tech startups, it's an important first relationship. It's one of the first investments that raise. Partners, business developers and meet with tech founders recognize that in the early days, they're going to be taking some risks in extending credit to the founders.
A partner at a med-tech law firm focused on startups is looking to pick founders much the way our investors do because they want to back founders with their time and the time of their associates to help them get started. They want to choose the ones that they think have a high probability of success, which entails the ability to raise financing, attract advisors and board members, and develop a device that's going to help patients, and there's going to be strong demand for it.
Working with a med-tech law firm is step one. There are a number of them available. I always recommend Evan Ng at Dorsey & Whitney. Dorsey is a full-service law firm. They are headquartered in Minneapolis, the home of a lot of med-tech but they also have offices all over the country. I'm based in the Bay Area. I have been working with Evan Ng and his team out of Palo Alto, California, and the heart of Silicon Valley for many years, and I couldn't recommend it enough.
At the core, convertible note financing starts as debt. It's a loan that accrues interest.
There are other law firms that do a great job as well though but the key point is to reach out to law firms and pitch them your idea. Tell them how big the market is and how much unmet need exists for patients, providers, and the general healthcare ecosystem. If you can get them to take that meeting, they are going to guide you through the development of your C corp. There could be a recommendation depending on the state where you live or certain conditions unique to you as the founder's situation. They could recommend a California C corp. There are some features of the California C corp that are founder-friendly.
Step one, find high caliber healthcare law firm that specializes in startups and asks them questions, “How often do your clients go from startup to seed financing to venture back?” That journey for founders is a unique one that once you've done it, you will understand some of the key steps of that process. For a full-service healthcare law firm that specializes in startups, they can do this very quickly. It's important at the beginning to think with the end in mind.
With the end in mind means you don't want to organize and incorporate your business in such a way that you are going to have to redo key features of the corporation to take financing from sophisticated or high net worth individuals. Step one, get the right law firm, pitch them the way that you would pitch an investor, get them to believe in you, the problem you are trying to solve for the right term.
That brings us to step two. Why would we do a convertible note? What is a convertible note? How will that set us up for success in the next financing? At the core, convertible note financing starts as debt, and think of the notes as an I owe you. It's a loan that accrues interest. There are templates that exist. One is specifically called the SAFE or the SAFE note. The advantage of the SAFE note is they are standard founder plus seed investor-friendly, and generally an accepted standard amongst the investment community, the legal community, and founders that these are good terms.
Back to the convertible note, the way it works is you are saying to your seed investor, often a good friend, family member or someone that believes in you. You are basically saying what a convertible note is, "I have no idea what the value of this business is yet because we have a lot of work to do." Rather than negotiate or make up a price per share where the investor would buy stock in a company in the form of equity, you say to the investor, "If you invest $100,000, it's going to accrue interest like any other loan."
At some point in the future, when the business is able to raise qualified financing, which is a defined term within most convertible notes, and often the financing of $1 million or more, at that point, there will be a price per share determined. For all the noteholders that invested at the earliest stage, their $100,000 investment, which has now accrued interest is going to convert to equity. That's why this instrument's called a convertible note.
I put my $100,000 at a 5% interest rate. In one year, the company owes me $105,000. At the same moment in this scenario, the company raises qualified financing of over $1 million. It's qualified financing because someone came in at a time when they did diligence on the business, and they have effectively looked at the progress that has been made with the convertible note financing. They determined, "This business is worth $10 million."
There are $10 million shares outstanding and so they are going to invest in a pre-money valuation of $10 million. That is now going to put the price per share at $1. That priced round, what it signals and indicates to the early noteholders is the founder and the company was able to take their riskiest money that they raised through the convertible note as a loan.
They had been able to accomplish enough milestones developmentally that a professional investor that invests in equity financing and has the ability, skillset, and experience due diligence the value of a business is getting to effectively use all the work that professional investor has done. Now, the VC or the investor invests in the business at a dollar per share. The $100,000 investment that the convertible note holder made has accrued 5% interest and it converts not at a dollar per share but rather a discount to a dollar per share. It's usually between 15% and 20%.
To go through the numbers, the investor invests $100,000 in the convertible note. A year later, a VC comes in and prices around at a dollar per share and leads that financing greater than a million dollars. This triggers the qualified financing conversion described in the convertible note. The seed investor who invested in the convertible note their $100,000 has now grown to $105,000 with a 5% interest, and it converts at $0.80 per share. That is the feature. What this does is it allows the people that know you and trust you the most to invest at the stage where they are backing you as the founder.
With that in mind, the convertible note is a great way to enable your most supportive people to invest in terms that are fair, and industry-standard, and then after you have succeeded, they get a better price per share, and the new money that comes in. This is the convertible note and it is enabled by first setting up a Delaware C corp.
For those of you that are attorneys and experienced founders, there are other ways to raise financing. There are significant advantages, pros, and cons to the LLC, S corp, or limited liability partnership. I'm not giving legal advice. I'm telling you my experience as a multi-company and multi exit founder of what has been most effective for me. Take this information with a grain of salt. Always seek legal advice and do your own diligence. I hope you enjoyed the episode.
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Thank you very much for reading. I hope you are enjoying the short office hours sessions. We are going to continue to have guests and founders share their experiences. During this journey, because the UNMEET NEED show is focused on healthcare entrepreneurs and specifically physician founders, I want to get some of these key experiences that I have had out so that with all the great ideas that entrepreneurs have, we can bring more of them to the market. Stay tuned for new founder interviews. We have a number of them scheduled in the upcoming episodes. As always, if you have any questions, go to JeffSmith.co and if you are interested, I'm happy to speak with you for 15 to 30 minutes and answer any questions you might have.
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About Jeff Smith
I am a serial entrepreneur who loves building products, teams, and companies that improve human health. I have founded 6 companies with 2 exits to date. I am currently CEO of Providence Medical Technology, a commercial stage medical device business I founded with over $20mm in annual revenue and more than $60mm in capital raised. I am fascinated by the societal impact of innovation waves and seek opportunities to apply these forces to large under-served global markets.
Helping entrepreneurs navigate company building is exciting for me and doesn't feel like work. I enjoy matching great founders with supportive investors and work with boards and management teams to develop strategies, organizational alignment, and business processes.
I provide consulting and advisory services to early-stage companies using emerging technologies to solve problems of modern society. My expertise includes company formation, debt & equity financing, product development, executive recruitment, commercialization, and licensing & acquisition.