Convertible notes are one of many fundraising options for start-up entrepreneurs making it essential to understand the pros and cons of convertible notes. The way that convertible notes work is that an investor loans an agreed amount to a company which is then converted to equity during a later investment round.
While convertible notes are becoming increasingly popular with entrepreneurs because they are a great bargaining chip to entice investors, they do have distinct advantages and disadvantages like any financial agreement.
Today, I’m going to list the most salient pros and cons of convertible notes so that you can decide, either as an investor or a start-up entrepreneur, if convertible notes are a good option for you.
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How Convertible Notes Work
A convertible note is a short term debt agreement with an investor. Instead of accepting investment for immediate equity, the investment is treated like any other loan.
However, instead of paying back the loan plus interest with cash over time, the investor receives a guarantee of stock in the company to that valuation.
This transaction is fully completed in the next fundraising round. For example, an investor provides a loan of $100,000 to a start-up. A convertible note agreement is signed for that amount. Once the start-up has reached its initial goals and requires further investment, other investors are attracted to the business.
At this stage, as new investment is brought in, the initial investor receives $100,000 worth of stock in the business. On top of this, more stock is given based on any accrued interest on the loan.
In this way then, convertible notes are usually seen during the earliest stages of start-up development. They are a hybrid of debt and equity where equity is later provided at the same valuation of the principal investment plus any interest accrued.
But how do you know if a convertible note agreement is better for your situation than a straight-up investment for immediate equity?
Below is a video where I go more in detail on how convertible notes work.
The Pros of Convertible Notes
When thinking about the pros and cons of convertible notes it is convenient to understand a few of the most important ones.
Convertible notes are simple documents that include any agreed interest rate, valuation cap, maturity date, and other provisions. They do not require the complexity of a share or common stock issue. Because of their simplicity, such an agreement is easy to draw up between the investor and the startup. This means investment can be secured much quicker.
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Anyone who has bought a house will know the pain of hidden legal costs. Whether it’s a loan agreement for a business or straight equity for investment swap, hiring legal professionals to ensure everything is above board can be costly. Because of the aforementioned simplicity of a convertible note, administrative costs are significantly more affordable.
The simple structure of the convertible note means fewer complications later on, especially when provisions like a valuation cap are included.
Early valuations of the start-up or precarious. It is difficult to know the true value of equity at the beginning of the start-up journey. Convertible notes defer such negotiations to a later investment round when the company is more fully formed and a fair percentage can be determined.
For investors, a convertible note agreement has a valuation attached to it – a value cap. This means that during later investment rounds, the company cannot be valued above that limit. This provides a better return price per share for the initial investor.
Most convertible notes include a discount rate. This means that investors using this method can convert a loan plus accrued interest into the equity of the company for a lower price per share than new investors during subsequent investment rounds.
The Cons of Convertible Notes
As part of the pros and cons of convertible notes, every investment type has advantages and disadvantages for both the investor and the target business. Convertible notes are no different. Let’s now take a look at some of the most salient disadvantages of using convertible notes.
The most pressing issue when using a convertible note is what happens when a company cannot, or refuses to, attract financing during a later finance round. Provisions can be attached to the notes during negotiation to partially avoid this situation. However, sometimes investors simply do not get their investment back. This usually occurs when a start-up is going to go out of business.
Start-ups tend to have a significant burn rate during their first few years. This is due to heavy investment in infrastructure, securing patents, developing marketing strategies, and overall product development. Because of this burn rate, it can push business towards subsequent investment rounds when the valuation for the business is still uncertain.
This means the investor may not get the best deal for an equity return.
To avoid the above concerns, the automatic conversion of equity can be agreed upon before the convertible note is signed. However, this can then put restraints on the business when trying to attract later investment, hurting the start-up’s ability to entice new investors who are not happy with such a pre-agreed valuation.
During subsequent investment rounds, new investors may feel the need to pressure convertible noteholders to alter their agreement. This sometimes happens because the investor with the convertible note has a valuation cap and automatic conversion price in place.
This can impede outside investment because too much equity is being returned to the original investor.
Most convertible notes also accrue interest like a loan. However, this interest is simply added to the equity valuation when being converted during a later investment round. If the interest has not been accurately or fairly calculated, this again can result in too large a stake of equity being returned to one investor. Again, this can put off other investors.
Learning More About Fundraising
To summarize the pros and cons of convertible notes are fascinating and have become one of the key ways to invest in start-ups. I hope today’s post has helped you decide if such an agreement is best for your needs.
Remember that storytelling plays a key role in fundraising. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the pitch deck template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
FULL TRANSCRIPTION OF THE VIDEO:
Hi, everyone. This is Alejandro Cremades, and today we’re going to be talking about what is a convertible note? In this video, basically, what I want to do is, I want to touch on the reason behind why convertible notes exist, what kind of structure it is, and then the different types of convertible notes that you’re going to be putting together as you’re looking to raise financing. So with that being said, let’s get into it.
Essentially, convertible notes are a way to raise money. You can either raise money via equity, or you can raise money via a convertible note round. Typically, convertible notes, you’re going to see them at an early stage. That’s when the company is doing a seed round, a Series A round. You can actually use this type of financing at any point in the game.
A convertible note is a document that is going to be consisting of a convertible note purchase agreement and then also as a form of note. That’s basically it. So now, let’s jump into the terms.
When it comes to the terms, basically, there are going to be three main things that you need to take a look at. One is the interest that you’re giving. That is an interest that you’re giving on the investment that you’re receiving, and typically that is accruing in a 12-month period of time.
The next thing is the discount. The discount is whatever discount you’re giving that investor that is putting money in on that convertible note, and the discount is going to be applied on the next round of financing, which is going to be the equity round that you’re going to be raising over the course of time where those notes are essentially converted.
With the discount, right now what I’m seeing is anywhere between maybe 20% to even 30% discount. Typically, 20-25, but that’s something that you want to check with your corporate lawyer. Then, on the interest, I’m seeing anywhere between 5-10%, but again, that’s something that you want to consult with your lawyer.
Then the other thing that you really want to keep an eye for is the valuation caps. Now, really, the beauty of convertible notes is that you don’t have to put a valuation on the business. It’s like equity rounds where right away, you’re talking about the valuation of the business, the price per share.
On convertible notes, you just keep it super simple, and that’s the beauty of why people like it at an early stage because they can move fast. But essentially, the last thing is the valuation cap, as we are discussing, where indirectly, you’re putting a valuation on the business, and the cap is that ceiling that you’re establishing for yourself.
So in terms of how those specific terms, let’s say the interest, the discount, and more specifically, the cap would really come into play. Let’s say that you are raising a round right now of 2 million dollars in a convertible note. If you put a valuation cap, just to throw in a number, of 10 million, and maybe a discount of 20%, and an interest of 8%, basically, the way that it would play out is that if you do an equity round, let’s say in 24 or 30 months from the moment that you actually closed that deal, that convertible note – let’s say if you do the equity round with a valuation of, for example, 20 million. You’ve already set a valuation cap of 10 million.
What that means is that those convertible noteholders are not going to be converting at a 20-million-dollar valuation. They’re going to be converting at the 10-million-dollar valuation with the interest, let’s say, of 8% kicking in.
Here is where it really gets interesting. If the valuation is not at 20 million, but the valuation is under 10 million, for example, like a number like 9 million, then they’re not converting at the 9 million. They would be converting at the 9 million with the discount on that price, which would be the 20% and also with the interest that they would be accruing. That’s essentially the way that they would come in. In some instances, there are people that put the valuation cap; in other instances, they don’t put the valuation cap, and probably, the sophisticated investors are going to require that.
Now, let’s talk about the maturity date. When it comes to the maturity date, you really want to be careful when you’re discussing with investors. There are investors that are going to go at it for the wrong reasons, and the maturity date is critical. The reason for this is because typically, you’re going to be establishing a date when that convertible note becomes due.
For example, if you’re signing a convertible note today, and maybe in 24 months, you’re saying that note is going to be due, then you need to either repay that note to the investor that is giving you the convertible note, money, or you are going to have to have converted that note into equity, meaning that there has to be happening there an equity financing where that note is converting into equity.
If there is no equity around that has happened, then there’s a tricky part there where you are going to require the investor for an extension of the note until you are able to get to an equity financing. So for that reason, I have seen instances where the note becomes outstanding, and then there’s no real alignment or no agreement between the investor and the founder. Ultimately, the founder doesn’t have money to repay back the convertible note. Then the investor basically forces the company to go out of business. With that being said, you want to be very, very careful.
In terms of price, and then also the timeline for a convertible note as opposed to, for example, on equity rounds, convertible notes are super-fast. I mean, literally, you can get the two documents, the convertible note purchase agreement and the form of note done by the attorney in literally less than two weeks because they’re going to grab a couple of templates, throw in the terms that we’re talking about – the interest, the discount, the cap, and then also the maturity date. Then, that’s it. That’s the document that you need to engage investors.
But here’s the thing. It’s also cheaper. For example, you need to move very fast. If you’re running out of time, I think that convertible notes are interesting because typically, the amount of money that you’re looking at spending is anywhere between $5,000 to $10,000 as opposed to, for example, with an equity round where you go into full-blown negotiations with a potential lead investor, and that amount in legal fees could go all the way north of like $20,000.
So, I think that in order to move fast and also in order to keep it simple in terms of pricing, convertible notes are also a great option. But, again, you want to make sure that you’re confirming this with your corporate lawyer.
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