⚠️ Legal Dangers of Convertible Notes and How to Avoid Them
Last updated: 2021-05-26 (originally published on 2016-09-26) — by Alex
Are you a startup and confused about Raising seed funding? In our first article of this Convertible Note series, we outlined the basics and benefits of fundraising via Convertible Note. Many startups have different ideas to grow your business but couldn’t implement it due to lack funds. For many startups, Convertible Note financing is probably the best way to raise funds.
But just as most things will have their pros and cons, there are also risks to using a Convertible Note. Tweet this
Read case study: Bid4Ad: Raising our first $1 million with Zegal
In this second article of the Convertible Note series, we address the disadvantages of using Convertible Notes, and highlight the elements that Founders and investors should be aware of while using them.
Convertible Notes are based on the assumption that the startup will proceed to raise a second round of funding.
But what if this doesn’t happen? For instance, what if your startup is acquired before the maturity date?
As a Founder, you should set your Convertible Note to mature at a date where you are confident you will have secured sufficient funding. Moreover, the agreement should state the amount of financing required for the conversion from debt to equity to occur. In short, Founders need to ensure that they receive enough funding and verify the stage at which the Convertible Note converts into equity. As a proactive measure, the terms can specify that the Convertible Notes will not convert until there is a second round of financing.
How does this affect VC investment?
Founders and investors should always agree on a valuation cap in a Convertible Note. A valuation cap is set out to assist conversion calculation and other issues on legal certainty. Second round investors (VCs) however may base their investment decision on that valuation cap, which can affect the valuation of the company. Moreover, seed investors may gain a greater portion of equity than expected, which may deter VCs from investing. However, all the above problems merely depict the reality of business. Since the seed investors took a higher risk, they are entitled to a higher return, and most VCs are willing to accept that.
Short-term Convertible Notes
The final thing to look out for is the Short-Term Convertible Note, which is normally used as a bridge between different stages of financing. As these convertible notes are short-term, they may not contain a cap. This would entail that the investor only gets a small discount with all the risk borne.
A well-drafted Convertible Note will help to avoid the above issues.