A convertible note is a type of short-term debt in the form of a loan used by a seed investor looking to invest in a start-up that hasn’t yet been valued explicitly.
A convertible note agreement could be drafted to handle this type of arrangement that trades a loan, to be repaid at a future date, for equity in an issuing company that is not yet vetted.
The aim is to get in on the ground floor and provide options for future financing for the company.
Suppose you’re looking to raise capital for your start-up but are not ready for valuation. In that case, you need to read these 5 important things you should look for in a convertible note.
1. Interest Rate
Any convertible note can be considered a loan since it requires an investor to invest money that will accrue in the same manner as any debt or loan with interest. The only difference is that the convertible debt would pay out interest in the form of shares rather than cash.
The interest rate is the added amount to the principle that will be due when the note converts. Interest rates remain low and track alongside the current market rates since it is a form of equity conversion.
Here is an article about one form of convertible note, the senior convertible note.
2. Discount Rate
When it is time for the note to mature, the original investor is due a discount on shares purchased. The amount due is referred to as the discount rate. This is the benefit of the investor funding early in the process.
For example, if the discount rate is 10% and shares are sold at $5 a share, the investor can purchase the same shares at $4.50 per share. This allows investors to not only take advantage of the discounted shares but also to buy more shares than those paying full price.
Here is an article with a good explanation of discount rates.
3. Maturity Date
The maturity date is when the convertible note is matured, and the debt converts to equity. There are two ways for this to happen:
- Via Maturity Date: the maturity date guarantees that at some point, the investor will have the option to convert their accrued interest into company equity, regardless of the company's financial status. This date is decided when agreeing, and typically it covers two years.
- After the Maturity Date: even if the maturity date has passed, the debt does not convert automatically. Instead, the investing party(ies) must elect to convert it. This form of conversion isn’t common, mainly since forcing a conversion at this time could put the company in financial straits, which doesn’t benefit the investor. Plus, letting the money ride and waiting out the storm will result in a larger equity amount.
Here is an article about key terms in a convertible note agreement.
4. Valuation Cap
The valuation cap is the upper limit on the amount investors are willing to pay in exchange for equity in the next fundraising round. It stands to reason that an investor would want a lower valuation cap since it gives them a higher percentage of the company.
How does this work? Let’s say a company is valued at 20 million dollars, and the valuation cap is limited to two million dollars. At this rate, a $200,000-dollar investment would be worth a 10% share of the company instead of a 1%
Here is an article for a more detailed explanation of valuation caps.
5. Liquidation Preference
The liquidation preference is an important part of the exit or payout of a convertible note. It delineates the order of money paid out to preferred and common stockholders. Usually, you will see this expressed as a multiple of the investment, such as:
- 1X the investment
- 2X the investment
- 3X the investment
The most common liquidation preference is 1X return, which means the investor would get their money back before common stockholders would receive theirs. If the liquidation preference is a 3X return, the investor will get back triple their money before the common share stockholders.
The importance of this portion of a convertible note agreement comes to play if the company goes belly up and there is not enough money to pay back all of the investors and stockholders.
As more startups crop up, convertible notes and the like will continue to rise in popularity. And even if the process seems cut and dry, there are still complexities in an agreement like this that warrant review from an experienced lawyer.
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