The many ways a company can raise capital reminds me about the wide variety of Zombie movies. Now I see that there are Zombies in Cuba – who, of course, grunt with a Spanish accent, and in Equatorial Africa, where they attack the coastal towns. There are slow zombies one can easily outrace and fast running zombies who appear to be track stars. So every time I think of convertibles, I do think of them as Zombies: hard to kill, easy to create, and reliable. Still I am perplexed about how Zombies can survive without feeding or walking around aimlessly. And sometimes I am equally confused on how convertibles are discounted or what is the valuation cap.
The most frequent discount rate I have observed in Silicon Valley has been 20%. Now I compare that number against the loan interest rates for risky SMBs at about 36% APR. Or even the 18%-24% APR factoring rate against inventory for SMBs with little or no credit. And, in stark contrast to startups, these SMBs should have some cash flow and probably has been operating for years. So the note discounted rate of 20% is a relative bargain for startups with little or no revenue history.
Then you have a valuation cap which projected value is anticipated by the maturity date of the notes, somewhere between one and two years. Basically the company is providing a ceiling valuation for the note holders. Now I have calculated valuations. But this magic number is purposely chosen from low figures that should satisfy the risky nature of the notes. Of course, if the number is too high, then the note holders just get a fair exchange. And if the post-money valuation skyrockets, then the note holders have the benefit of a real bargain.
But as one can see, there are yardsticks to establish a price. It boils down to the cost of capital and the financial projections. There is a saying on Wall Street when establishing sales projections: under-promise, over-deliver. So in the case of the valuation cap, you are always better off to price the discount at the most pessimistic value. And once one sees what community banks or lending clubs charge for interest rate, the discounted rates seem to be a bargain.
Simple Advice for Entrepreneurs on Capital, Strategy, Legal Services, Management, Entrepreneurship, VC Funding and other things - Juan Ramon Zarco 