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.
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?
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.
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.
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