How Do Convertible Notes Work?
Last updated: 2021-05-27 (originally published on 2019-10-21) — by Ching Hei Cheung
Convertible notes are a common component of every company’s lifecycle. When used correctly, they can offer both the business and seed investors leverage in pursuing major fundraising benefits. They can give rise to greater efficiency and overall pay-off if you familiarise yourself with the components of convertible notes.
During the early stages of every business lifecycle, convertible notes are often chosen as the primary mode of investment financing. They are most often offered to seed investors by startups who wish to delay establishing a valuation until a later round of funding. Whereby the outstanding balance of the loan is automatically converted into equity. This serves as a convenient and efficient means of fundraising for startup companies by redirecting resources and time to the business’ essential content instead of finances. But, this method also presents its own disadvantages and risks, which could potentially serve as detrimental to both the angel investor and the company itself.
Seed Stage Businesses
Amidst this fragile time for every startup company, there is often insufficient information about the business. So there isn’t much to go on to curate a truly definitive valuation that investors can base their financing decisions on. During this unpriced round, for almost every startup the revenues and assets aren’t large enough for venture capitalists to come up with a valuation that they and the founders of the company can mutually agree on. Thus demanding the need for an alternative method of financing, such as offering convertible notes.
A convertible note acts as a form of short term debt that converts into an investor’s equity after a conversion event occurs known as a conversion trigger. For example, when a startup raises a certain amount in its next fundraising round, or another milestone in its lifecycle.
Ultimately, the note serves to defer and delay valuing the worth of the startup in the early stages of its development to avoid disagreements. This also prevents against the risk of committing to a value that’s too low or too high. When a startup has developed into further stages of development, it can generate more data points and reach certain metrics. These will ultimately provide investors with the data to arrive at an appropriate and accurate valuation, which is consistent with empirical evidence supporting the worth of the company.
Thus, investors are able to provide startups with capital in the form of debt through the issuance of a convertible note. This ensures that the investment will convert to shares after the conversion event.
The stage of the business’ next financing round is known as equity financing. The investor may or may not be able to immediately benefit from having its loan turned into equity, depending on whether these rounds are priced or not.
If the shares and equity are priced and available for taking, this serves as a conversion trigger. Whereby the seed investors’ convertible notes automatically turn into equity. The amount of equity that the investor is able to benefit from is determined by the purchase price given by the investor as capital. This is divided by the conversion price, which is the investors’ amount given during this priced equity financing round.
Ensure that all components of the negotiation process are documented clearly. And that the agreement itself is executed with precision. Use a reputable convertible note template that will take you through the entire process from negotiations with investors to due payment of the agreed investment amount.
Valuation Caps & Discount Rates
As previously mentioned, one key component in determining the amount of equity that the investor can receive is the conversion price given during equity financing rounds. This amount is further determined by two main characteristics of all convertible notes: a valuation cap and pricing discount. These are additional clauses added into convertible notes. They are used in order to compensate the angel investor for the additional risks associated with investing in a startup business with no valuation in the earlier round of its lifecycle. For more information on valuation caps and discount rates, check out the Shareholder’s Resolution to Issue Convertible Notes template document.
Pricing discounts vary depending on the degree of risk associated with investing in a particular startup company or business. These incentivise investors to take a chance on startups who are still at the seed stage and may not have reached a stable level of developmental growth. Through offering a pricing discount as opposed to a price that may be offered at a later stage or financed round, seed investors are able to purchase shares at between 10 to 30 percent discount instead of paying prices that later investors will have to pay.
Alternatively, valuation caps also serve as a crucial facet of determining the conversion price given by the seed investor. This proposes limits whereby the investor can convert their investment into equity at a predetermined valuation. These two components, in conjunction with each other, help to produce a seed investor’s valuation, or conversion price. This will be given during the next equity financing round.
Here are the best ways for a company and investor to avoid any ambiguities regarding a convertible note. allowing all parties to enter into negotiations and issue shares through convertible notes securely and beneficially:
- Clearly address all terms of the agreement
- Address an automatic conversion clause within an Ordinary Shares Term Sheet
- Reiterate these terms onto a Convertible Note Instrument that the investor can subscribe and intermittently refer back to via a Convertible Note Certificate.
Interest rate in convertible notes have two accrual methods- simple or compounding. This is usually coupled with a given time frame determining when and how the interest rate is calculated. And thus, how the lender of the money, in this case a seed investor, will profit from this loan.
As with most other components and clauses included within a convertible note, the interest rate is negotiable. Therefore, both parties should be cautious when discussing the terms of the agreement making use of a Convertible Note Term Sheet which allows you to document and keep track of the progress of your agreement.
Seeking out methods of venture funding for an early-stage startup is no easy feat. And when coupled with the daunting task of determining the definitive valuation of a newly launched company, it can seem like an impossible task. Due to the myriad of complexities associated with valuation, many startups choose to opt for offering convertible notes to angel investors instead.
While this mode of early-stage financing is capable of benefiting both founders and investors in the long run, the company must be cautious and utilise term sheets, certificates, and instruments in order to stabilise and document the progress of these agreements. This way your company can minimise the risk of bankruptcy and achieve its full potential, profiting both its founders and investors. Zegal can assist you with issuing this form of investment financing with ease every step of the way.
This article does not constitute legal advice.
The opinions expressed in the column above represent the author’s own.
Ching Hei Cheung is a first-year law student and aspiring solicitor studying at the University of Bristol. She is involved in a myriad of extra-curricular activities such as debating team where she has obtained first place in a national competition judged by a panel of legal professionals from Baker McKenzie, commercial awareness society and pro-bono society, in order to refine existing skills in public speaking and negotiations, as well as develop a greater understanding of the commercial market that encapsulates the everyday workings of the legal sector.