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?
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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