Venture investors willing to deploy capital in these uncertain markets may find opportunity in the convertible note space.
Since May 2022, the venture capital market has largely slowed down in terms of the number of deals and the amount invested, largely driven by huge multiple (think valuation) contraction. According to Crunchbase, “global venture funding measured at $144 billion in 1H 2023, down from $293 billion in 1H 2022”. This drop in funding has been driven by a number of likely factors, including:

  • Increases in interest rates increasing the cost of capital
  • The ‘freeze’ of the IPO market, ie., venture capital backed companies have less chances for an ‘exit’
  • Tenure funds preserving capital for existing companies to help them survive until they can raise funds again at attractive valuations

Similar to convertible bonds in the public markets, convertible notes are debt that convert into equity (usually preferred shares) in the next capital raise round or similar qualified financing event. These are spelled out in the promissory note–actual legal document representing the convertible notes. It’s worth noting that until the bonds are converted into equity, they represent debt for the startup issuing the convertible notes. They will accrue interest, usually not paid in cash, which converts into equity along with the principal of the note.

Convertible notes are usually used as bridge financing between rounds. This lets companies offer preferred terms to strategic investors ahead of a capital raise. These funds can be used as proof-of concept or growth capital, helping a company hit milestones before opening the round. The potential benefit may be that the subsequent funding round occurs at a higher valuation or raises more capital if the company is able to achieve the milestones articulated for the convertible round.

Generally, convertible note investors will demand some sort of discount to the subsequent round valuation as a way of building ‘upside’ or additional return into the note. The discount range usually is 10% – 30%. This discount is a method of compensating the convertible note investors for additional risk that they are taking, since a minimum valuation is not guaranteed for the subsequent series round.

Valuation caps can also be included. Valuation caps are the highest valuation amount that the convertible note will convert at (thus capping the entry point for investors). The lower the valuation cap relative to the next raise valuation, the higher the return for the convertible investor.

Additionally, being preferred shares, investors will get additional rights such as information rights (access to financials, etc.); observer board seats or board seats, depending on the size of the round; warrants, or other beneficial terms that de-risk the convertible for the investor. Finally, convertibles usually have a maturity date set twelve to twenty-four months out, which motivates the company raising the convertible to execute their next funding round within that time period.

Deals may have slowed down and valuations are depressed. But convertible notes still provide startups a way to delay the valuation question, contingent on a valuation cap, and still raise capital. Valuation caps, discounts (currently around 20%), and additional rights are present in the convertible notes being raised. Any changes to the convertible market will likely be contingent on the IPO market ‘unfreezing’.

We continue to see opportunities in the mostly revenue generating Series A – Series B companies that are looking for bridge capital before their next round. There is no sector-specific focus for current rounds or geographic focus on the activity we see. Valuations look to be improving from prior rounds overall though there are some exceptions to this. These insights can be attributed to the focus Validus has on companies earlier in their lifecycles.

Part of why we focus on ‘early stage’ venture companies (Series A – Series B) is because there are many opportunities to invest in those companies at more attractive multiples (valuations) when compared to later stage companies that rely on the IPO market for an exit and to drive valuations. We prefers companies that either have a path to revenue, a path to profitability, or are looking at opportunities based on technologies so massive that the potential outweighs the medium-term focus on cash flow generation.

So, if you are a venture investor willing to deploy capital in these uncertain markets, you may find some interesting opportunities in the convertible note space.

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Validus Growth Investors, LLC seeks to invest in companies at every stage of their growth. From startups to publicly traded companies, our research identifies inflection points that have the potential to produce meaningful growth and income for the clients we serve.
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