What's a Convertible Note?

A convertible note is a type of financial instrument commonly used in startup funding rounds. It is a debt instrument that has the potential to convert into equity in the future. In this article, we will delve into the basics of convertible notes, their mechanics, benefits, potential risks, and their role in fundraising.

Understanding the Basics of Convertible Notes

Definition and Purpose of Convertible Notes

A convertible note is essentially a loan that is issued by a startup company to an investor. Unlike traditional loans, the purpose of a convertible note is not primarily to receive interest payments or repay the principal amount. Instead, its main purpose is to provide a mechanism for the note to convert into equity at a later stage.

Convertible notes are commonly used by early-stage startups when they are in need of capital but have not yet determined the valuation of the company. This flexible financing option allows startups to raise funds without having to agree on a specific valuation at the time of investment.

Key Features of Convertible Notes

Convertible notes come with several key features that make them attractive to both startups and investors. Here are some of the important features:

1. Conversion Mechanics: The conversion of a convertible note into equity typically occurs during a subsequent funding round, such as a Series A financing. The conversion is triggered by certain events, for example, if the startup raises a specific amount of investment or reaches a predetermined valuation.
2. Conversion Price: The conversion price is the price per share at which the convertible note converts into equity. It is usually determined at the time of the subsequent funding round and is often discounted from the price per share paid by new investors.
3. Interest Rate and Maturity: Convertible notes typically accrue interest over time and have a maturity date, by which the note must be either converted into equity or repaid. The interest rate and maturity terms are negotiable between the startup and the investor.
4. Conversion Rights: Convertible note holders often receive additional rights, such as anti-dilution protection or preferential treatment in the event of an acquisition or liquidation of the company.

One of the advantages of convertible notes is that they provide a win-win situation for both startups and investors. For startups, convertible notes offer a way to secure funding without the need for an immediate valuation, allowing them to focus on growth and development. Investors, on the other hand, benefit from the potential upside of converting their loan into equity if the startup succeeds.

Another important aspect of convertible notes is the conversion price. This price is typically set at a discount to the price per share paid by new investors in a subsequent funding round. This discount serves as an incentive for early investors to provide capital to the startup, as they are rewarded with a lower conversion price and the potential for greater returns.

Furthermore, convertible notes often come with conversion rights that provide additional protection and benefits for investors. These rights can include anti-dilution protection, which ensures that the investor's ownership percentage is not significantly diluted in the event of a down round, and preferential treatment in the event of an acquisition or liquidation of the company.

In conclusion, convertible notes are a popular financing option for early-stage startups due to their flexibility and potential for conversion into equity. By understanding the basics of convertible notes, both startups and investors can make informed decisions when it comes to raising and providing capital.

The Mechanics of Convertible Notes

How Convertible Notes Work

Now let's dive deeper into how convertible notes actually work in practice. When an investor invests through a convertible note, they receive a promissory note that outlines the terms of the investment. The note will specify the principal amount, interest rate, maturity date, and conversion mechanics.

Convertible notes are a popular form of financing for early-stage startups because they allow investors to provide funding without determining the startup's valuation immediately. This flexibility benefits both parties, as it defers the valuation discussion to a later funding round when more information about the startup's performance and market potential is available.

During a subsequent funding round, if the conversion trigger is met, the investor has the option to convert their debt into equity based on the predetermined conversion price. The number of shares received upon conversion is calculated by dividing the outstanding principal and interest of the convertible note by the conversion price.

The Conversion Process Explained

The conversion process can vary, but it generally involves the following steps:

1. The startup and investor agree on the terms of the convertible note, including the conversion mechanics and conversion price.
2. The investor funds the startup by purchasing the convertible note.
3. If the conversion trigger is met, the investor has the option to convert the convertible note into equity. This typically occurs during a subsequent funding round.
4. The investor receives a predetermined number of shares based on the conversion price.
5. The investor becomes a shareholder of the startup.

It's important to note that the conversion price is usually set at a discount to the price per share in the subsequent equity financing round. This discount serves as an incentive for early investors to provide capital to the startup at a riskier stage and rewards them for taking that risk. Additionally, convertible notes may also include a valuation cap, which sets a maximum valuation at which the debt will convert into equity, ensuring that early investors are appropriately rewarded for their early support.

Benefits of Using Convertible Notes

Advantages for Startups

Startups can benefit from using convertible notes for several reasons:

• Flexibility: Convertible notes provide flexibility in terms of valuation, allowing startups to raise funds without having to determine the precise value of their business at an early stage.
• Quick and Simplified Process: The process of issuing convertible notes is generally quicker and more streamlined compared to issuing equity. This can be advantageous for startups in need of immediate capital.
• Delayed Equity Dilution: By raising funds through convertible notes, startups can delay the dilution of equity until a subsequent funding round, enabling more time for the company to grow and increase its valuation.

Advantages for Investors

Investors are also drawn to convertible notes due to the following advantages:

• Potential Upside: If the startup succeeds and experiences significant growth, the conversion of the convertible note into equity can lead to substantial returns for the investor.
• Minimal Negotiation: Since the main terms of the convertible note are often standardized, investors can benefit from a simplified negotiation process compared to negotiating equity terms.
• Early Investment Opportunity: Convertible notes allow investors to participate in the early stages of a startup's growth before a valuation is established, potentially offering more favorable investment terms.

Potential Risks and Drawbacks

Risks for Startups

While convertible notes have their advantages, startups should also be aware of potential risks:

• Future Valuation Uncertainty: By deferring the valuation of the company, startups take the risk that the valuation may increase significantly before the conversion occurs, resulting in higher dilution of equity.
• Interest Accrual: Convertible notes accrue interest over time, which can add to the financial burden for startups if they are unable to convert the notes into equity.
• Conversion Not Guaranteed: If a startup fails to meet the conversion trigger, the convertible note may not convert into equity, potentially leaving the investor in a stronger position compared to the startup.

Risks for Investors

Investors should also consider the following risks when investing through convertible notes:

• Early Stage Risks: Investing in startups at an early stage carries inherent risks, including the possibility of failure or slow growth.
• Lack of Control: Convertible note holders typically do not have voting rights or the ability to actively influence the startup's decisions until the conversion occurs.
• Liquidation Preference: In some scenarios, preferred investors may have preferential treatment in case of an acquisition or liquidation, potentially affecting the returns for convertible note investors.

The Role of Convertible Notes in Fundraising

When to Consider Convertible Notes

Convertible notes are typically used in specific scenarios during fundraising:

• Seed Funding: Convertible notes are commonly used for seed funding rounds when the valuation of the startup is uncertain and investors are focused on supporting the initial stages of the business.
• Bridge Financing: Startups that need short-term capital to bridge the gap between funding rounds may opt for convertible notes as a temporary financing solution.
• Collaborative Investors: Convertible notes can be attractive to investors who want to support early-stage ventures but prefer to defer valuation negotiations until the company has further progressed.

Alternatives to Convertible Notes

While convertible notes are a popular funding instrument, startups and investors also have alternative options to consider:

• Seed Equity: Startups can raise capital through the sale of equity, which provides more certainty in terms of valuation and share ownership.
• Safe Agreements: Simple Agreement for Future Equity (SAFE) agreements are another alternative that allows startups to raise funds without establishing a valuation, while providing more investor-friendly terms compared to convertible notes.
• Preferred Stock: Investors can opt for traditional preferred stock investments, which offer clear ownership rights and voting privileges.

Conclusion

Convertible notes offer a flexible and efficient way for startups to raise capital during early-stage funding rounds. They allow startups to postpone the determination of their valuation and provide investors with the potential for future equity upside. However, it's important for both startups and investors to carefully consider the risks and benefits associated with convertible notes and evaluate alternative financing options based on their specific circumstances.