In the last two Finance Friday posts, we discussed debt and equity, the two most common types of financing available to start-ups. Last Friday, we did not post anything (sorry!), as we were very busy running the first of six workshops in the Village Capital Nairobi Programme at the GrowthHub! But now we are back to continue our discussion about specific types of financing, today talking about grants and hybrid securities. Next time, we will move on to discuss even less common, but more creative, alternatives for financing.
Grants
It may have occurred to some entrepreneurs that we have not yet addressed what might at first seem to be the most appealing source of funding available: grants (money that never has to be paid back). Grants are sometimes available from governments and foundations if your business is providing a service that helps achieve certain goals. Most businesses, however, should probably not hold out too much hope for such funding. First, compared to the amount of money available as debt or equity, grants are relatively rare, and they are seldom suitable for the large-scale funding that will become needed if your start-up grows quickly. Second, grants are generally not a sustainable funding source, as priorities of grant-makers shift, and grant funds may even dry up entirely during difficult economic times. Finally, grants often do not provide the right incentive for a business to really be competitive and get to scale. While this is beginning to change, many grantmakers require little accountability – as long as you spend your money along certain guidelines, there are often few checks to ensure you are making effective and efficient decisions. (There are exceptions, such as the Tandaa grant in Kenya, which over the years has been increasing its accountability requirements.) Other forms of funding encourage you to make good decisions by requiring a return on the investment, with significant repercussions if you fail to deliver. To top it off, investors who see businesses consistently applying for grants may hesitate to become involved, as this practice may signal a lack of seriousness and focus in building your business. Thus, you should consider the downsides carefully before making a habit of relying on grants to finance your business in the long-term.
Hybrid Securities
There are a number of vehicles that combine debt and equity, such as convertible notes/bonds, which begin as debt and convert to equity after a certain time period or based on pre-specified criteria. (Bonds are essentially a type of loan, but whereas loans are not easily traded, bonds are highly tradable.) Such vehicles are normally used for start-ups whose value is not easily calculated. For instance, in GrowthAfrica’s case, investment in companies in the Village Capital programme uses a convertible note, beginning as a loan, which, if not paid off after a certain period, automatically converts into equity. However, in this case, as in most, the automatic conversion is a last resort. The two better outcomes, from the investor’s point of view, are that 1) the entrepreneur simply pays back the loan or 2) the outstanding balance of the loan is converted into equity when another investor offers financing. To understand this second case, an example is useful (explanation below):
In this example, the 1st round investor has invested $100,000 in Company X using a convertible note. The interest rate is 18% per year and the note is convertible to a 15% equity stake after 24 months if the loan is not repaid and no other investors materialize. If another investor comes along, though, the first investor’s remaining investment converts into equity at a 25% discount to whatever price the new investor is paying.
Fortunately for Company X, 16 months later, another investor provides a second round of financing. This investor ends up infusing $500,000 in capital for a 10% stake. Because the company has 100,000 shares in total, that means the investor is paying $50/share for 10,000 shares. Company X has only been paying the interest on the convertible note, so the principal for the first investor is still $100,000. Thus, due to the arrangements of the note, the 1st investor now converts the remaining $100,000 principal into equity at a 25% discount to the price paid by the 2nd round investor. That is, instead of paying $50/share, the 1st round investor only pays $37.50/share, purchasing 2,667 shares and now owning roughly 3% of Company X.
This is just one example, but the specifics of convertible notes are completely up to the investor and, to some extent, the entrepreneur, and vary widely. So as an entrepreneur, the parameters you need to consider if you use a convertible note are primarily: the interest rate on the loan, the repayment period, the discount given to the investor when converting to equity (assuming a 2nd round of financing), and the conversion rate to equity if you do not repay the loan or cannot secure more financing. There are also other types of hybrid securities, but they generally share the feature that they initially pay a dividend or a set interest rate and then provide the option to convert into equity at a later date.
What other hybrid securities have you come across in your journey to find financing? Have you encountered convertible notes with very different terms than the ones in this example?
Check back next Friday for our final post on types of financing, covering topics like revenue and profit sharing, supplier credits, and more!
Filed under: Business Tagged: convertible note, debt and equity, entrepreneurship, financing, grants, hybrid securities 
