What to Know About Convertible Notes
Posted: Jan 17, 2023 12:16 PM ET
A convertible note is a form of debt that can be converted into equity in a company at an agreed-upon date and valuation. This form of financing is popular among early-stage startups because it allows them to raise capital without valuing the company and issuing shares immediately.
In this article, we will learn about convertible notes, how they’re used, and when they should be.
Why Not Just Raise Equity?
When a startup is incorporated, they are typically worth very little so using a convertible note can provide more flexibility in terms of valuation, as the conversion price is not set until a future round of funding. This allows startups to delay the determination of their valuation until they have more concrete metrics to show potential investors.
Additionally, convertible notes typically have simpler and shorter legal documentation compared to equity financing, which can be appealing to startups looking to save on legal costs and time. Finally, convertible notes can also offer more favorable terms for investors in terms of interest rates and conversion discounts, which can help attract investors who are looking for more favorable returns.
What is a Convertible Note?
A convertible note is a form of short-term debt that converts into equity. The holders receive interest as discounted equity shares in lieu of regular payments. These notes are commonly utilized by early startups when securing a seed round and larger companies who require an influx of capital in advance of the next fundraising initiative, which is often referred to as a “bridge round.” Convertible notes have a few key components:
- Conversion Discount: The investor will receive shares at a discounted rate upon maturity or the next “qualified financing” event (the next round of funding).
- Valuation Cap: The maximum price that the investors will pay for their equity in the company’s next fundraising round.
- Interest Rate: When the debt is converted to equity, this interest rate will be added to the original amount invested.
- Maturity Date: Convertible notes, similar to other forms of debt, generally have a set maturity date for when the investor may request full repayment from the company; this date is mostly created with the intent of setting a timeline for the subsequent round of funding.
In 2010, Paul Graham wrote a post titled ‘High Resolution Fundraising’, which explained that convertible securities facilitate more precise and customized pricing during early-stage funding. This type of note can provide cash to assist with attaining a Series A and thereby attract a dependable lead investor at a fair price.
What Happens at Maturity?
When a convertible note is issued, both the investor and founders anticipate that the debt will be converted to equity in a financing round within 1 – 2 years; however, if this does not occur on time, investors can receive repayment (including interest) by the maturity date.
On rare occasions, businesses are taken over before their original equity round or choose not to increase any capital. This produces tough circumstances. It is evident that investors are not making speculative bets on startups only to receive back their principal and a marginal interest rate. VCs and angels gain by having great successes in their portfolio. Therefore, it is highly recommended for founders to add phrases into their convertible notes that explain what investors can expect in such an event.
Paying Back a Convertible Note
Convertible notes are just like any other form of debt where the principal plus interest must be compensated. Ideally, a successful startup would not have to give back a convertible note in cash. But, if the maturation date shows up ahead of a financing round, investors can opt to demand their resources back. This could result in the company going bankrupt if it doesn’t have the necessary funds available. The situation can become even more difficult if there are multiple convertible notes outstanding.
When You Should Use Convertible Notes
Convertible notes should be used when they help you close your seed round faster.
Oftentimes, the most difficult part of a startup’s seed round is securing an investor commitment. It is often said in finance that investors commonly inquire about who else is involved. VC’s are sometimes thought to be influenced by this ‘herd mentality’.
Despite being frustrating for entrepreneurs, investors are often right on the mark. A startup needs resources and if they don’t find investors that recognize its value, it will likely go under. An investor won’t get their money back unless more people believe in the business.
No one assumes more risk than angel investors or early stage venture capitalists. Convertible notes let founders provide better deals to investors who assume this risk, which eventually furnishes you with an opportunity to expand your business.
When You Should Not Use Convertible Notes
Convertible notes should not be used when they overcomplicate your capitalization table.
If a company raises money with multiple convertible notes, the cap table can become complicated. Founders may find themselves in an uncomfortable position, especially if they fail to raise the next round of financing on time. Because convertible notes are still debt prior to their conversion, founders may be liable to pay back cash they don’t have.
Final Considerations
Convertible notes are a common choice for early-stage startups looking to raise capital. While it offers some benefits, there are also some drawbacks that should be considered by both the startup and the investor. Here we will briefly highlight the advantages and disadvantages for each.
Advantages of Convertible Notes for Startups:
- Quick and simple: Accessing capital through a convertible note is usually faster and simpler than doing a traditional equity round, as it does not involve evaluating the company’s value.
- Flexibility: Delaying an evaluation of the company’s worth may be beneficial for startups, allowing them to focus on growth and product creation while they build up more traction.
- Lower dilution: Convertible notes permit startups to acquire capital without having to allocate a large quantity of equity shares, which could reduce the ownership of current shareholders.
Advantages of Convertible Notes for Investors:
- Early access: Investors can get involved in a potential startup business early on and benefit from the potential growth of the company.
- Valuation protection: Convertible notes often have a valuation cap, providing investors with protection from overvaluation by limiting the price of future equity conversion.
- Interest and maturity: Investors can benefit from convertible notes since these typically offer interest payments and have a predetermined maturity date.
Disadvantages of Convertible Notes for Startups:
- Cost: For startups, the interest and legal fees associated with issuing convertible notes can be costly.
- Conversion discount: Existing shareholders’ ownership may be diluted if the conversion of notes to equity is subject to a discount in certain scenarios.
Disadvantages of Convertible Notes for Investors:
- Risk: Placing funds into a pre-existing startup carries significant risk and there is no assurance that the investment will be profitable.
- Lack of control: Convertible noteholders are not granted the same degree of authority within the company as equity shareholders.
As we’ve seen, convertible notes can be a useful tool for early-stage startups looking to raise capital. However, it is important to carefully consider the advantages and disadvantages before making a decision. Startups should seek advice from experienced investors and legal professionals to ensure they make the right choices for their business and their investors.
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