Convertible notes are one form of downside protection that we use in these cases. The entrepreneur may think their seed round should be valued at $20 million, so we may create a note structure and take a discount to the next round to defer that valuation discussion. So if the business is valued at $40 million in the next round then that initial $20 million valuation starts to look better. If the founder can continue to execute at that rhythm then the note structure will give them an attractive valuation at each stage - but if they can’t then we will get a discount on a lower valuation.
Preference shares can also provide some level of downside protection for investors in the case of a liquidation event. Sometimes there may also be anti-dilution clauses that protect investors in case of a down round.
Whether it’s preference shares and anti-dilution clauses or convertible notes, this downside protection changes the return that the entrepreneur would get if we were just an ordinary equity investor. We may on occasion use these terms to allow us to accept a higher valuation than we might otherwise be comfortable with. Without downside protection we'd want to be 100% confident that the valuation is a real valuation for this business – for example, that it’s equivalent to what we would get back if the business was sold today.
Simon Cant is Co-Founder and Managing Partner at Reinventure Group.
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