If you’re an investor or a startup, convertible notes can provide benefits to both sides. Investors, such as venture capitalists, ‘friends and family,’ and angel groups, want reassurance. A convertible note offers a low-risk investment vehicle that helps startups meet initial capital demands while satisfying investor low-risk tolerance.
In this article, we help you learn everything you need to know about convertible notes. Let’s start by looking at convertible notes explained:
Convertible Notes Explained
Convertible notes are investment instruments that are similar to short-term debts. Investors invest in convertible notes during seed financing rounds that eventually convert to equity, such as preferred stocks, until maturity or conversion. This option works well for startups that want to reward early investors.
The most significant advantage of convertible notes is that they don’t force investors to value the company beforehand. A startup’s valuation will be relatively unknown until the Series A financing round, generating more valuation data points.
This article further explains convertible notes.
How Does a Convertible Note Work?
A convertible note works by converting debt to equity upon conversion. However, the investment’s value changes based on several variables, including conversion discounts, interest rates, loan terms, and valuation caps. As a result, startups and investors may encounter a combination of all four elements.
Key Terms to Know in Convertible Notes
Convertible notes contain legal and financial language that describe the terms and conditions . While they’re similar to other contracts, they have vital provisions that make them unique as an investment vehicle. Not understanding them can lead to unintended consequences in the future.
The key terms to know when working with convertible notes include the following:
Term 1: Conversion Discount
- Risk : Convertible notes carry more risk in early financing rounds.
- Reward : Conversion discounts reward investors for waiting to convert debt to equity.
- Time : Longer investments equate to better discount rates.
Term 2: Interest Rate
- Like a loan : Convertible noteholders should receive interest on the principal investment.
- Events : The convertible note accrues interest after issuance and until conversion or repayment.
- Flexibility : Upon conversion, investors can convert interest to additional equity.
Term 3: Loan Term
- Position : Loan terms should offer startups enough time to raise equity.
- In general : Typically, loan terms last between one and two years.
- Optional : Investors can wait to convert shares if the startup doesn’t raise enough money.
- Planning : Issue loan terms with unform maturity dates when dealing with numerous investors.
Term 4: Valuation Cap
- Early compensation : Valuation caps reward investors for risks during early investment rounds.
- Simple : Startups can offer valuation caps in conjunction with conversion discounts or as a standalone feature.
- Better outcomes : Valuation caps can potentially lead to more significant investor ownership percentages.
As you can see, convertible notes offer incredible flexibility to the startup while making the investment more attractive to investors. A real-world example can help you understand how convertible notes work better.
Let’s take a look at the following scenario:
- Startup A issues a convertible note to investors
- Startup A sets the conversion discount at 25 percent
- Startup A puts the valuation cap at $10 million
- During a Series A round, the startup only receives a $5m valuation
- Investor convertible notes convert at the 25 percent discount since the valuation cap was not met
- If the startup raised over the $10 million, then shares would convert at the valuation cap
In the preceding example, the convertible note offered the investor an “either-or” option after the Series A investment round. You can negotiate and structure your convertible notes to include these provisions as well. However, some startups only wish to offer a convertible note cap or a discount.
Goods and Bads of Convertible Notes
Convertible notes have advantages and disadvantages. While they offer a tremendous investing opportunity to investors, they also have their drawbacks as well. Regardless of your position, consider the pros and cons of convertible notes.
Here are the good aspects of convertible notes:
- Good 1. Low risk : Since convertible notes are loans, investors and startups can avoid incorrect valuation issues. This situation is perfect when the initial valuation is unknown.
- Good 2. Pre-valuation : Investors can move toward ownership based on pre-valuation values. They can potentially receive a much bigger reward than investors coming in during later rounds.
- Good 3: Voting power : Convertible noteholders don’t have voting rights. The startup is free to operate without managerial control from noteholders.
- Good 4. Simple : Convertible notes are structured simply. Most initial financing rounds become complicated through other vehicles, whereas convertible notes generally don’t.
- Good 5. Fixed income : Investors are generally offered a fixed income with convertible notes. While they will eventually become equity, investors view the reassurance of a convertible note as attractive.
Now, here are the bad aspects of convertible notes:
- Bad 1: Bankruptcy risk : The startup could go bankrupt, which would also include your convertible note.
- Bad 2: Debt : Startups and incubators want to raise equity versus debt. Convertible notes are debt, which carries a risk from the beginning.
- Bad 3: Control absence : Since investors don’t have voting rights, they may not feel comfortable investing large sums of money.
- Bad 4. Uncertainty : Investors have trouble assessing how long they should hold out before converting to equity. If they allow too much time to pass, they lose their investment.
- Bad 5. Lack of clarity : Another risk investors face is that startups may fail to meet repayment terms. If they can’t raise sufficient equity, they won’t have enough money to repay the convertible note.
The benefits and disadvantages of convertible notes depend upon the perspective of the startup and investor. What is profitable for one said becomes a loss for another. You should always seek legal advice from convertible note lawyers if you have questions to avoid making mistakes. This strategy ensures that you’re always putting profitability and stakeholders first.
Check out this article to learn more about the implications of convertible notes.
Convertible Notes vs. Equity
The most significant difference between convertible notes vs. equity is that convertible notes are a form of debt that may eventually becomes equity. Equity typically presents in the form of a stock purchase agreement or SAFE note, or simple agreement for future equity. SAFE notes give investors the right to purchase shares of preferred stock shares during a future financing round.
When To Use a Convertible Note?
Startups issue convertible notes during their first investment requests. Seed investors, such as venture capitalists and angel investors , utilize convertible notes during accelerator investments. Startups and investors can prioritize debts by issuing senior convertible notes to ensure a fast payback.
You can also use a convertible note to avoid the burden of equity transfers. Rather than owing money to investors, the startup can repay them through preferred equity or senior convertible notes. As such, they no longer need to waste excessive amounts of time, energy, and money using convertible notes as an investment vehicle.
Get Help with Your Convertible Notes
The drafting and negotiation of convertible notes is challenging. Instead of leaving your next investment to chance, work with investments lawyers to help you navigate the legal issues surrounding them. Doing so can only strengthen your legal rights while ensuring that you are forging ahead practically. Connect with a legal professional in your state today to learn more about your options.