What is a convertible note? When a startup is seeking funding, there are two main methods that they can use. One is in the form of debt, and the other is in the form of equity. However, in some cases, the investor may lend money to a startup and later want to convert the loan into ownership.
That is where a convertible note comes in. A convertible note allows investors to convert their loan into equity once the company starts to achieve its performance goals. This type of loan involves the investor lending money to the company and once it is attractive or a specified event occurs the loan is converted into equity for the lender.
While convertible notes seem straightforward at first glance, there are other stipulations involved to help guarantee that everything works out well for both the startup and the investor. In addition, the way convertible notes work can be somewhat confusing for a first-time entrepreneur as well.
So if you are a startup founder or an investor who is thinking about using convertible notes, then we suggest you keep reading.
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What exactly is a convertible note?
A convertible note is a kind of loan which lets investors turn debt into equity at a certain time. Seed investors can use this investment vehicle to invest in a startup that isn’t ready to be
They start out as short-term debt and are turned into shares of the company that issued them. Investors lend money to a new company, and instead of getting back their money plus interest, they get shares in the company. Once a certain goal is reached like when the company is officially valued for formal investments, the convertible note automatically turns into equity.
The main benefit of issuing convertible notes is that it is a lower risk for investors. They are still owed something, even if the company isn’t the huge success that the founders expect it to be in the long run. Lower risk can mean it is easier to raise this type of financing for entrepreneurs.
Many investors and new businesses aren’t sure if a convertible note is a debt or stock. In a nutshell, it’s a bit of both. On a company’s balance sheet, convertible notes are shown as debt until they are turned into equity. When they are converted, they become shares of the business. As a debt instrument, a convertible note also has an end date and can earn interest over time.
How do convertible notes work?
The convertible note functions similarly to a traditional debt instrument in the absence of a conversion event.
If the business experiences a conversion event, then the initial amount on the note plus any accumulated interest will convert into equity. The price at which a convertible note is converted to equity is determined by one of two factors:
- Valuation cap: A valuation cap is the highest value in which a convertible note can be turned into equity. If the valuation cap is $5M and the post-money valuation is $10M, then the holders of the notes invest as though the value was $5M. The terms for investors are better if the cap on the value of a convertible note is lower.
- Discount rate: A discount rate, rather than a precise value cap, provides note holders with a discount on the valuation when they convert. For example, if the discount rate on a convertible note is 30% and the post-money value of the equity round is $10M, note holders can participate at a $7M valuation.
Some convertible notes include a value cap as well as a discount rate. As a result, the note will convert at the lower of the two possibilities, benefiting investors.
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Example of a convertible note
An investor loans $25,000 for a convertible note with an interest rate of 8% and a discount of 20% applicable at the time of conversion. If the company raises another round in 18 months, and the company sells equity at $3.50 per share, the note will have earned $3,000 in interest. So the note investor will be owed $28,000 by the company. With the 20% discount, the price to convert the note into new stock is $2.80 per share, and the investor gets 10,000 shares of the new stock.
If the investor had waited to buy the stock instead of using the convertible note, they would have only gotten 7,143 shares. This shows that there is a big reward for the convertible note investor taking the risk to invest earlier.
What are some key terms of a convertible note?
As we have mentioned earlier, a convertible note is only as effective as the terms it consists of, and there are many different terms that come together to make these notes effective. If you are going to use a convertible note, be it as an investor or a startup, you need to first understand its terms.
So without further ado here are some key terms of a convertible note:
Rate of Interest:
Convertible notes have an interest rate associated with them since they are, effectively, loans. The distinction is that interest on convertible notes is paid in stock shares rather than cash. When the note is converted into equity, the interest rate is applied to the principal amount. Because the majority of the value derives from equity conversion, interest rates are usually modest and in line with current rates.
When the note is ready to be converted into stock, the investor will get this discount rate. This compensates for the risk that the investors faced by investing so early. They may acquire more shares with the money they put in early than later investors. If the discount rate is 20% and shares are sold for $1 per share in a subsequent round of investment, the investor’s equity will be valued at 80 cents per share, which is 20% less than the real share price.
The maturity date is the date when the investor can ask the company to repay the loan in full.
A valuation cap limits how much investors will end up paying for their shares in the next round of fundraising. When they are low, investors benefit because they get a bigger share of the business.
Provisions for conversion:
A convertible note converts into stock in the future. When a future equity investment surpasses a threshold, conversion happens. The original principal with accumulated interest turns into new equity.
In addition to accumulated interest, which buys convertible note holders more shares than if they waited to participate in the equity round, they frequently receive other incentives for investing early. If a qualifying financing doesn’t materialize before the maturity date, some convertible notes automatically convert to stock at a fixed valuation.
Ready for some more in-depth information about what is a convertible note and how it works? Check out this video I have created. You’re sure to find it helpful.
What are some benefits of convertible notes for startups?
By now it should be clear to you that convertible notes come with certain advantages that set them apart from other funding sources. Here is a list of some of the benefits you can expect by using convertible notes.
- Cost-effective: Comparing convertible notes to priced equity rounds that require a valuation, administrative and legal costs are usually much lower for convertible notes.
- Negotiations are simpler: When compared to priced equity rounds, there are lesser terms to negotiate in convertible note rounds. This makes negotiations easier and faster to finalize.
- Faster access to money: Startups can get funding in a shorter amount of time since the process is quicker and easier. So if you need funding on an urgent basis, convertible notes might be a great choice.
- Keeping control over the company: Convertible note holders, as debt holders, typically have no voice in how a company operates until their notes convert to stock.
What are some benefits of convertible notes for investors?
Now of course a convertible note is not just beneficial for startups. It also comes with its own unique benefits for the investors as a reward for the risk they take when investing in a company during its infancy.
Here are some of the advantages of convertible notes for investors.
- Ability to negotiate the terms of the note: Because they are participating at an earlier stage, investors have greater power to negotiate better conversion terms, such as a lower value cap or a greater discount.
- Investors accumulate interest: Investors may get interest payments that can be turned into shares of stock. So the more interest is owed to the investor by the company, the more stock the investor can claim.
- Saves time and effort for investors: Investors may be able to close more transactions more quickly and earn more money using convertible notes if the complexity and associated expenses are reduced.
- Convertible note holders enjoy high liquidation rights: As debt holders, investors have more rights in liquidation. Convertible note holders usually have a high liquidation preference, so convertible note holders get paid before shareholders.
What are some common disadvantages of using convertible notes?
While there are plenty of benefits of using convertible notes as stated in the previous section, it is important to note that there are always potential cons as well. If you are going to use convertible notes, then it is important that you know the pitfalls of this mode of funding, here are some potential disadvantages of using these notes.
Failure to Secure Future Financing:
There is always the possibility that the company may be unable to get more credit or equity capital in the future. If the company is unable to get more funds when the note expires, it is unlikely that the note will be repaid.
If a company fails to repay a convertible note, it could go bankrupt. However, if an investor forecloses on a business, they probably won’t recoup most of their money. Both parties lose in this situation. Before investing in a convertible note, investors and entrepreneurs must consider all of their options, including the possible causes of failure.
Giving Away Equity Shares:
The biggest problem for a company with a convertible note is that it has to give up equity that could be worth a lot more than the loan it is linked to. This is especially true when the valuation caps are kept low for the convertible note. Startups could give away a big chunk of equity if they grow quickly and in a way that was not expected in the early stages.
Poorly planned convertible notes:
If a business has too many notes or loans that are not properly set up, it may be putting itself at risk in the future. Most convertible notes are composed of a single contract known as the note purchase agreement.
This contains all of the loan’s terms. The investors are then given promissory notes detailing the date and amount of their investment. However, if companies issue convertible notes with various conditions at different periods, cap table issues may make them difficult to resolve in the future.
Convertible notes are being increasingly used by startups to raise funds quickly. With their benefits for the investor, they also make it simpler for investors to invest in a promising startup. So, now that you know everything about convertible notes, you are in a much better position to start using these notes for your very own funding or investment applications.
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