Convertible Debt Notes in Startup Investing Demystified - Part 1: What is a CDN?
This 3 part series will explain the nuances of a CDN, explore the utilities of this instrument in early-stage investing and talk about the pros and cons related to each stakeholder.
Identifying a true valuation?
If you are an entrepreneur or an early-stage investor, you know the difficulties of structuring a deal that is founder-friendly as well as protective to the investor. The negotiations and the back and forth to come to the same page sometimes take longer than the actual act of presenting the company and convincing the investor. On the crux of these negotiations is the question of the valuation.
As my Uncle (Former head of SME Lending of the Kenyan National Bank) once told me, valuation is not a science but an art form. Valuation is a lot easier and precise on developed companies that have predictable cash flows, established competitors that are in the same sector, and market-priced assets, but when it comes to valuations of early-stage startups, the art of valuation gets complex. There are so many different ways to arrive at it, its mindboggling.
Do you do a discounted cash flow (DCF) on the projected profits of a pre-revenue company or on a subjective multiple of minuscule revenues that may not accurately define the worth of the company? How do you price the value of a nascent brand or a company whose assets may be its specific relationships with complex supply chains? EBITDA multiple on a loss-making entity or the fabled checklist valuation? There’s no easy answer here, but there is an easy out for investors and founders, the convertible debt note (CDN).
What is a CDN?
A compulsorily convertible debt note is essentially an investment into the company with the conversion of equity set for a later time and benefits added for the investor at the time of conversion. Money is given to the company and it is shown as debt on the company books until a conversion event occurs. A CDN is an equity investment in the company with the issuance of the exact number of shares pushed to a later conversion date. These are the possible convertible events:
a) The next round of funding
b) Lapse of the time period of the debt note
c) Liquidation
The convertible debt note effectively allows the founders and the investor to kick the conversation about valuation down the road. Not only does this save time for both the parties involved, but also saves the heartache of a founder to price his newly born baby.
Types of CDN:
There are 3 types of CDNs:
1) Discount
2) Valuation Cap
3) Cap + Discount
Simply put, the discount-based CDN allows a discount to the CDN investor on the valuation that the next investor receives at the time of conversion.
For example, an investor invests 10 Cr with a CDN at a 20% discount. After a 12-month period, the company receives an additional investment of 10 Cr at a 100Cr Valuation. The CDN will convert to equity at a 20% discount of the 100Cr. Valuation i.e. 80 Cr. So, the equity stake of the CDN investor will be 12.5% with a current value of 12.5 Cr.
A valuation cap-based
CDN puts a valuation ceiling that the CDN holder will receive at the conversion event.
Using a similar example, an investor invests 10 Cr with a CDN at an 80Cr. Cap. After a 12-month period, the company receives an additional investment of 10 Cr at a 100Cr Valuation. The CDN will convert to equity at an 80 Cr. Valuation as that is the valuation cap for the investor. So, the equity stake of the CDN investor will be 12.5% with a current value of 12.5 Cr. If the valuation is lesser than the cap, the conversion is done at the current valuation.
A cap + discount CDN is a hybrid of the previous 2 types which requires a discount of the valuation if it is under the cap value and at par with the cap if it is over it.
I hope this helps explain what a CDN is and how it can be deployed. Part 2 will talk about the suitability of a CDN ( is it the right instrument for your startup?) and what are the key factors to consider when structuring a CDN.