Everything you ever wanted to know about convertible notes
Convertible notes are commonplace in seed investment discussions and should be fully understood by both investors and startup founders so that their financial relationship stays on favourable terms. In this post we outline the basics of convertible notes and what should be included when drawing one up. Then, we highlight the pros and cons of this form of convertible debt so that you can decide if they’re the right option for you and your business.
What is a convertible note?
A convertible note is an agreement of a conversion to equity between an investor and a startup during the seed round of funding. This comprises an investor being given equity in the business instead of principal plus interest, which is the more traditional option. Whereas an investor or investment company would receive principal plus interest in exchange for their investment, this is not the case with a convertible note. A convertible note may also be used alongside future rounds of financing.
Another main feature of convertible notes is that they do not require a company valuation to be carried out. This means that convertible notes are particularly useful for founders of early-stage companies and those who may only be in the idea stage of their business. A company valuation can then be left for the Series A financing round when more analytical information can be known about the company.
What should a convertible note include?
There are a few key terms that you should look out for or include when organising a convertible note. These include the:
A maturity date is the date when a convertible note is due and when the company needs to repay it.
The discount rate should stipulate the cost reduction that an investor will be given in the following financial round. It should take into consideration the extra risk the investor undertook by investing in the business early.
In the same vein, a valuation cap is an extra advantage for investors who provided investment funding early on. A valuation cap provides a maximum limit at which the convertible notes will convert into equity.
Convertible notes will often gain interest since money has been lent to a company. Instead of being repaid in cash, the interest in this case is added to the principal invested, which will ultimately increase the number of shares that should be issued when the conversion into equity takes place.
Pros and Cons of Convertible Notes
Whilst convertible notes may seem like the best option for startups seeking seed funding, they do carry some disadvantages, too. Here are the pros and cons of using convertible notes.
- Simple structure
Founding and growing a startup can be time-consuming and complicated, so any option that can simplify this process is beneficial for business owners. Convertible notes can help make growing a startup easier, legally speaking. They are likely to be faster and cheaper to carry out than other investment agreements which will entail stock option grants, company valuations, and any appropriate tax implications.
- Pre-money valuation
As discussed, determining the value of a startup can be difficult if the business has not yet been able to ascertain the required data for this. Convertible notes are therefore a useful option for startup founders in the seed or early stages as company valuations are not required.
Since financial problems account for 16% of all startup failures (via www.failory.com), seeking substantial funding is crucial for the growth of a startup. For help with this process, contact our expert team at 7startup for more personalised information.
- Lack of certainty for investors
Although seed capital investors are granted equity rights as part of the convertible note, they also sacrifice certain rights typically associated with traditional shareholder agreements. These include voting rights, control rights, pro-rata rights, and liquidation preferences. This is a drawback as it could deter potential investors from agreeing to convertible note seed financings, as they would rather hold off any equity financing until the company can be better evaluated.
- Less control for investors
Convertible note investors also often have less control over their investments as they would as a typical shareholder, at least until the conversion is being carried out. Future investors into the startup often determine the value of the convertible loan note themselves and the convertible note holder may not be in agreement with their conclusion.
Convertible notes are a form of convertible debt that issue convertible note holders future equity in exchange for funding. Since a fair valuation of early-stage and seed companies is not usually possible, a potential investor may accept a conversion document instead of the traditional principal plus interest. Those who invest in startups early should be offered a conversion discount to account for the risk they took on when providing the initial investment.
Convertible notes are riskier for investors as they do not have the same rights with debt into equity agreements as they would as a traditional shareholder. They also often have less control over their investments and their future conversion valuation, which is likely to be determined by other future investors. However, this form of convertible debt agreement does offer extraordinary flexibility for startup founders as opposed to traditional forms of investment agreements.
This story was originally posted on 7startup.vc