You’ve progressed your enterprise from startup and angel capital raising rounds and are now ready to consider listing on the ASX. Your corporate advisor recommends a pre-IPO capital raise, particularly to enhance the strength of your story going into the IPO with important wholesale cornerstone investors and to prove your bona fides to regulators when you submit your pre-IPO In-Principal Application. The question is, how to structure that pre-IPO raise?
The Traditional Route
Traditionally, shares are issued for the pre-IPO raise. They are easily understood by investors and allow directors to pursue growth targets supported by equity and not by debt. Shares issued in the pre-IPO raise can also provide a compelling narrative about the progress of the enterprise in creating shareholder value if that value is accretive.
The Value Trap
A share issue however has one major drawback. I call this the value trap. In a growth phase, it is difficult for an enterprise to determine its value. If you issue the shares at a price too low, you are excessively diluting equity in the enterprise; too high and it will be difficult to complete the pre-IPO raise and subsequent IPO transaction. To overcome this issue, you might consider issuing convertible (con) notes.
I see con notes as an attractive alternative that are ideal for the pre-IPO raise. By issuing con notes, you can avoid the value trap discussed above. They normally have equity conversion clauses that are stated as a discount to the IPO price, usually between 20% – 30%. A con note issue allows an enterprise to defer its valuation to the more formal rigour of an IPO book-build process – your IPO broker will also be appreciative of the enhanced flexibility a con note raise allows in setting the ultimate IPO price.
The Accounting Conundrum
Convertible notes issued by pre-IPO enterprises cause an accounting conundrum. That is, how to account for the debt and the equity (conversion) portions of the notes, particularly as there is no traded market for the shares which could be used to anchor a price for that conversion option (which would allow it to be priced as a derivative).
When it comes to pre-IPO enterprises, the accounting standards are silent on this matter. Accordingly, the directors may consider, in consultation with their auditor, whether it is appropriate in this setting to split the debt and conversion component of the convertible note. Another drawback is that by splitting the debt and equity components, the accounting message of the value of the con note is somewhat obfuscated to readers of the financial report.
SAFE v Convertible Notes
Simple Agreement for Future Equity (SAFE) notes have been popularised by Y-Combinator in Silicon Valley. They have many features that are similar to convertible notes but with one key difference – no cash redemption requirement. This avoids the solvency issue endemic to convertible notes when they reach their maturity.
Consequently, SAFE notes are becoming increasingly popular in Australia, particular with pre-IPO tech companies. They will also make your auditor’s life much easier in signing off the going concern position of the enterprise. A key point to note, however, is that as they are generally convertible for a variable number of equity instruments under accounting rules, they are treated as debt rather than equity.
The key is for the enterprise is to control the message around these notes. That is, even though they are classified as debt under accounting rules, they really are part of the enterprise’s broader capital structure and not a crimp on solvency.
Conversion Upon IPO
Upon IPO, it is standard that convertible or SAFE notes convert into shares, making the capital structure post-IPO clear and legible. More and more often we see the conversion of notes into equity as a key pro-forma transaction that occurs as part of a Prospectus transaction. The conversion of convertible notes to shares may also aid the issuer in meeting shareholder spread tests upon IPO.
Commercially, your convertible note holders will also have an incentive to exercise their discounted conversion option and then have the ability to sell their shares on market, subject to any escrow rules that may arise as part of the IPO.
What is best for you?
While every option has its advantages, I foresee that SAFE notes – or convertible notes with no cash redemption features available to the investor – will become increasingly popular in the Australian pre- IPO landscape due to the clarity that this provides to note holders post-IPO.
If you would like to know more about how to best structure your pre-IPO raise, please contact your local William Buck adviser.