Overview of a Convertible Note Instrument
What is a Convertible Note Instrument?
A Convertible Note Instrument is a debt instrument that converts into equity under predefined conditions, typically in qualified financing, at a liquidity event, or on maturity date.
To raise funds by issuing convertible notes, you may either use a Convertible Note Instrument or a Convertible Note Subscription Agreement. If you have multiple investors subscribing for the same note, you should use a Convertible Note Instrument.
Contrary to a Simple Agreement for Future Equity (SAFE), a convertible note created under a Convertible Note Instrument is interest-bearing, has a maturity date, and specifies a minimum amount of funds to be raised at the equity financing.
When would you use a Convertible Note Instrument?
A Convertible Note Instrument is a type of short-term financing used in the early stages of startup funding. When a startup is looking for funding, a convertible note helps an investor to make the investment in the form of a convertible note so that they will get a stake in the company once the first stage of funding is completed.
Like a traditional loan, a convertible note also has its own terms and conditions for repayment but the main purpose of using a convertible note is to get the equity in the startup rather than paid back in cash.
What are the advantages of a Convertible Note Instrument?
A Convertible Note Instrument is a short-term debt instrument that converts into equity. When a startup is just in the idea stages and has yet to develop, valuation can be a problem. A convertible note solves this problem by moving the valuation to the future. The startup can get the funding it needs without having to accept a low valuation and the investor can get good value by investing in the company in its early stages.
These are the main advantages of a Convertible Note Instrument.
Low risk & high-efficiency : The main advantage of issuing convertible notes to investors as opposed to conventional debt financing is that it does not force the issuer and investors to determine the valuation of the company. This is especially useful in the case of startup companies as it may be difficult to determine the definitive valuation of a business that has yet to be taken into its true fruition.
Pre-valuation investments: Convertible notes allow issuers to defer valuation negotiations, thus, allowing the company to progress into later stages of funding to determine a fair price through more advanced metrics later on in the lifecycle of the business. One notable feature of convertible notes is that it typically includes a discount rate to the fully diluted price per share, thus benefiting investors who are willing to take the risk of investing in a company before a definitive valuation can be made.
What are valuation caps and discount rates?
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.
Pricing discount: Pricing discounts vary depending on the degree of risk associated with investing in a particular startup company or business. These incentivize investors to take a chance on startups that 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.
Valuation cap: 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.
Conclusion
Fundraising via Convertible Note Instrument has become increasingly popular among startups these days. 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.
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