Convertible Equity and Its Impact on Your Cap Table

Convertible Equity and Its Impact on Your Cap Table

As an entrepreneur, one of the biggest challenges you will face is raising capital for your business. There are several avenues available for funding, including taking out loans, having investors buy equity in your company, or issuing convertible equity.

Convertible equity, also known as a convertible note, is a type of financing that allows investors to loan money to a company with the option to convert the loan into equity at a later date. This article will discuss what convertible equity is, how it works, and its impact on your cap table.

Understanding Convertible Equity

Convertible equity is a hybrid form of financing that offers some of the benefits of both debt and equity. Unlike a loan, convertible equity does not have a set repayment schedule or interest rate. Instead, the investor loans money to the company with the expectation that the loan will eventually be converted into equity.

When the convertible equity is converted into equity, the investor receives a stock or ownership stake in the company. Typically, the conversion takes place when the company achieves a specific milestone, such as raising a certain amount of money in a future funding round. This milestone is usually referred to as a “trigger event.”

How Convertible Equity Works

When a company issues convertible equity, it will set the terms for the loan, including the interest rate, the conversion price, and the trigger event. The conversion price is the price per share of stock at which the investor can convert the loan into equity.

For example, if a company issues convertible equity with a conversion price of $1 per share, and the company raises $1 million in a future funding round at a price of $2 per share, the investor will convert their loan into 500,000 shares of stock.

Impact on Your Cap Table

Your “cap table” is essentially a ledger that keeps track of who owns what percentage of your company. When an investor buys equity in your company, their ownership percentage is reflected on your cap table. Convertible equity can complicate your cap table because it represents a potential future equity stake.

Until the loan is converted to equity, the potential ownership stake of the investor is not reflected on your cap table. This means that you will need to factor in the potential ownership stake when making decisions about future funding rounds or issuing new equity.

Additionally, convertible equity can have an impact on the valuation of your company. Some investors view convertible equity as a more risky investment because they do not have an immediate ownership stake in the company. This can lead to a lower valuation of your company, which can be a disadvantage when raising future rounds of funding.

Conclusion

Convertible equity can be an effective financing tool for businesses that are looking for funding but may not be ready to issue equity. It allows investors to loan money to a company with the option to convert the loan into equity at a later date. However, it is important to understand the impact that convertible equity can have on your cap table and the valuation of your company. As with any financing decision, it is important to weigh the pros and cons before making a decision.

When it comes to seeking funding for your business, convertible equity is just one option among many. Make sure to consider other options like business loans, traditional equity, or other financing methods to make the best decision for your company’s long-term health and growth.