When you have a startup company and are looking for a way to raise funds, you may have come across convertible notes. This is one of the most widely used methods of getting some much-needed equity into your business for short-term needs. When asking what is a convertible note, we’re here with the answers you need.
Convertible note definition
The purpose of a convertible note is to give new businesses that aren’t ready for 409A valuation the ability to partner with seed investors on a loan amount that will be repaid via equity once everything has been established, or predefined milestones met. With this in mind, the loan doesn’t have a principle or additional interest.
This can be especially helpful for businesses and even entrepreneurs that have minimum viable products or are in the early phases of startup and won’t have the necessary projections for a valuation to be properly made. Convertible notes are usually sought during the Series A financing stage.
How does a convertible note work?
At its core, a convertible note is the same as any other loan, it just varies in the way it is agreed upon and issued. An investor will take a look at the potential of a new company or idea and loan an amount that will help it to get off the ground. Once a valuation is awarded, the note typically converts into shares, so they will have equity in the company moving forward. In most cases, a convertible note template will be drawn up between the two parties, to outline terms like the due and maturity dates as well as the balance, and shares will typically be awarded after the Series A funding round has been completed.
Convertible notes are often issued when a business or idea is quickly gaining traction and can benefit investors as much as the individuals issuing, as they fast-track their way towards a priced round in a growing business. Securities can be a preferable payback method over traditional loan payments, as they have the potential to bring in greater returns if the startup ends up being significantly successful in the future.
Why are convertible notes useful?
One of the biggest attractions of convertible notes is that new businesses can obtain seed (or even pre-seed) funding before they have to offer any equity. Convertible notes offset the issues that can come with owners buying shares early and selling later and can provide a much better foundation when the company reaches valuation stage.
What are the pros and cons of convertible notes?
There are a lot of advantages and also disadvantages that can come when using a convertible note meaning that it can be worthwhile to understand both before putting any shares or collateral on the line (for owners and investors respectively).
The pros:
- Startups can better focus on their goals and potential for growth without having to worry about getting into debt
- Less complicated than issuing equity
- Investors will have the potential to significantly benefit from the growth of the startup
- Convertible notes can come with discounts and a low-valuation cap
- Minimal risks
- Fixed income for note holders
- Voting power within the new company
- A simple agreement with less paperwork than the alternatives (i.e. traditional loans)
The cons:
- It may be more difficult to secure future financing
- Giving away shares of equity in the business
- Poorly defined notes may cause issues down the line
- It can be time-consuming to negotiate
- Risk of bankruptcy
Examples of convertible note
To give you an idea of how everything works, a convertible note example will contain one of the following core aspects: a valuation cap, an interest rate, or a discount rate. Here are the ways in which these are likely to be used:
Interest rate only
In the instance of a convertible note that only features an interest rate, this will function in much the same way as a traditional business loan and won’t have any additional rules and regulations.
Discount rate only
If the convertible note on offer only features a discount rate, the startup and the investor will have the ability to achieve their financing goals with little fuss. This can be the most attractive option for both parties.
Interest and valuation cap
When owners want to make the most of their new businesses potential, notes that feature interest and a valuation cap will be converted at a set price and not at the actual valuation phase. This can help them to save on interest and increase the total cost of the funding awarded.
Discount and valuation cap
Making use of both a discount rate and a valuation cap can benefit investors by way of a higher saving per share given, while ensuring maximum funding is achieved for the business.
Interest, discount and cap
When a note has all of these features, it can be expensive for startups to get the funding they need.
Will your startup benefit from using convertible notes?
As with any type of loan, there can be positives and negatives when entering into a financial agreement, but these can be magnified when the debtor isn’t in a position to fully realise or express the long-term valuation of their asset. Having said this, convertible notes can be a viable option for the right individuals who are interested in both growing their idea into a lucrative business and investing in a high risk/high reward lending model. One of the best ways to ensure that the risks are minimised for all involved is to create a solid convertible note template that covers a host of eventualities and clearly defines the expectations and parameters for both parties.
There are a host of other financing options out there for entrepreneurs and new businesses such as crowdfunding for example, so it can be important to do some research before issuing convertible notes or putting your collateral towards one that may end up being a less-than-savvy endeavour.
If you have a startup and are looking for ways to maximise your productivity and provide a good work/life balance for your employees, it can be worthwhile to use tools like time trackers and leave management systems to ensure everything runs smoothly.
