While equity financing remains the primary way of raising early stage capital in India, convertible instruments are showing some early signs of picking up. A small number of startups, like price comparison site FindYogi or mobile publishing platform Mobstac have raised early funding using c-notes. Indusdiva, Gazemetrix, Instamojo, Chargebee and a few others have also used convertible instruments to raise funds.

For startups, the obvious advantage is that it won’t have to value the company early on and dilute too much equity. It is also less distracting, consumes less resources and time. For investors, its a quick way to enter a hot startup. But is it the right way to do it? What are the dos and donts?

“We weren’t sure of the valuation when we wanted money. So the idea was to raise convertable equity with a discount to the investor whenever we raised the next round. That way, things moved very fast for us,” Naman Sarawagi, the founder of FindYogi told NextBigWhat.angel

There’s been a lot of debate around it, especially in the Silicon Valley where convertible instruments are widely used. The general consensus is that it is startup friendly. And depending on how you look at it, not very investor friendly. But first, the basics.

What are convertible instruments?

Convertible debt, convertible loans, convertible notes, C-Notes? Same deal. Fred Wilson of Union Square Ventures explains it nicely

Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.

Convertible notes aren’t too much in favor with investors. When there are more startups chasing little money, Investors usually get their way. Getting their way means valuing the company at an early stage when valuations tend to be smaller and walking away with a neat packet if it goes big. Investing in convertible debts would mean losing out on an opportunity to buy more equity for less.

The trouble with C-Notes in India

“As long as the demand supply gap exists in India, convertible debts won’t take off,” Mukund Mohan, Director at Microsoft Ventures told me. Microsoft which recently realigned its startup activities under the Microsoft Ventures umbrella, invests in the form of convertible debts.

For startups, convertible debt is a good thing though. It takes off the pressure to value a company early on. “That largely cos the “angel investors” and founders are generally keen to work together more often than not some angel investors are keen to lend not just money but also, their expertise to the startup. In this scenario, getting into a valuation discussions can be quite adversarial,” says Kunal Walia, the Managing Partner at Khetal Advisors, a boutique investment bank.

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To invest through a convertible instrument that allows a discount to the next (typically) institutional round is often the best course, he suggests. Walia has observed a few new companies raise funds using convertible instruments in India recently. In his personal capacity, he has invested in Edureka and Simplilearn (before series A) using convertible instruments.

Watch out for Nasty Clauses

The one thing you want to ensure as an entrepreneur raising money through convertible debt is that you need to pay special attention to terms that define timeline of investment, convertible option expiry and what if anything needs to happen if the convertible condition is not met given a specified time frame, says Walia.

The key is to not get too excited about the investment and get over-confident about timelines. Some clauses like penal-interest, award of disproportionate equity to the investor etc need to be carefully examined.

“Its not the best thing in the world to add to that burden simply because you were too optimistic about reaching a milestone in a specific time,” he cautions.

Convertible Debt & Convertible Equity

Convertible equity is now the widely known cousin of convertible debt. Instead of paying back your debt in cash + simple interest at the end of the stipulated time, you now pay back in equity. At the time of conversion, your startup is valued and a portion of equity which is equal to the conversion amount is given to the investor.

There is a lot of debate going on about which is better. Valley based startup incubator Y-combinator, which is run by Paul Graham, used convertible notes a lot.

But then, they moved on to something they call “Safe” or “Simple agreement for future equity.” What is safe?*

A safe is like a convertible note in that the investor buys not stock itself but the right to buy stock in an equity round when it occurs.  A safe can have a valuation cap, or be uncapped, just like a note.  But what the investor buys is not debt, but something more like a warrant.  So there is no need to fix a term or decide on an interest rate. (source)

Antone Johnson, Founding Principal at Bottom Line Law Group writes on his blog

Advising investors, I would advocate for traditional convertible notes (with a valuation cap) over this new structure.  As Company counsel, I’d be open to switching to convertible equity, but frankly rank it lower on the list of priorities behind key terms such as conversion discount and valuation cap.

Depending on how you look at it, c-notes can be good & bad. Some interesting posts you must read are here & here.

*Updated. Hat tip: @vdurai

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