Startups will now be able to raise funds quicker and without handing over control to investors - but what are convertible bonds?
Companies in Bahrain will soon be able raise funds and establish employee share schemes through convertible bonds, after a new amendment to the Bahrain Commercial Companies Law introduced the scheme for the first time in the GCC.
Also referred to as convertible notes or convertible debt, convertible notes are essentially a type of short-term loan that is repaid in equity. It’s a particularly valuable form of fundraising when it comes to seed investment, as the notes are automatically converted into preferred stock shares for investors/lenders once a startup closes its Series A round.
Utilising convertible bonds for this type of high-res fundraising comes with several other advantages for emerging startups and SMEs, not least speed, as they can be issued in a matter of days, with a brief promissory document and at minimal costs. Some have also argued that they help founders retain more control of their startup than they would if issuing investors shares of preferred stock which can often come with control rights, a board seat and/or veto rights. On the other hand, convertible note holders are rarely given control rights of any kind and have no minority stockholder rights either. The method has long been championed in the US, most ardently by the likes of Paul Graham, entrepreneur, venture capitalist and co-founder of Y-Combinator.
The most interesting question here may be what high res-fundraising will do to the world of investors. Bolder investors will now get rewarded with lower prices. But more important, in a hits-driven business, is that they'll be able to get into the deals they want. Whereas the "who else is investing?" type of investors will not only pay higher prices, but may not be able to get into the best deals at all. Paul Graham
In a less direct way, convertible bonds have also been championed as a good way to incentivise and build loyalty internally, with the ultimate goal of retaining key personnel through employee share schemes. This element of convertible notes is seen by authorities in Bahrain as key to the development of the entrepreneurial ecosystem as they are keen to build on the World Bank ranking Bahrain in fourth place in a list of the world's most improved economy for doing business earlier this year.
“By granting employees the option to own or buy equity in the company, loyalty is increased, and employees are incentivised to act as owners,” Pakiza Abdulrahman, Head of Startups at the Bahrain Economic Development Board, said. “Convertible notes are a debt instrument that provide startups with a simpler, cheaper and faster means of raising capital without having to establish a valuation at an early stage. By granting incentives for early investors such as discount rates, this instrument can attract a wider range of capital. These developments are empowering new growth for locally registered businesses – especially startups and SMEs with global ambitions.”
Whether this will play out as expected in Bahrain is yet to be seen, but more will be clear by the end of the year, when official regulations governing convertible bonds are expected to be released.
Sign up for the daily Startup Digest.