{"id":30633,"date":"2019-10-21T02:01:45","date_gmt":"2019-10-20T18:01:45","guid":{"rendered":"https:\/\/zegal.com\/?p=30633"},"modified":"2023-01-18T14:00:05","modified_gmt":"2023-01-18T06:00:05","slug":"how-do-convertible-notes-work","status":"publish","type":"post","link":"https:\/\/zegal.com\/en-sg\/blog\/post\/how-do-convertible-notes-work\/","title":{"rendered":"How Do Convertible Notes Work?"},"content":{"rendered":"
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Photo by Roman Synkevych on Unsplash<\/figcaption><\/figure>\n

Convertible notes are a common component of every company\u2019s 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.<\/span><\/p>\n

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.<\/strong> 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\u2019 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.\u00a0<\/span><\/p>\n

DOCUMENT: Convertible Note templates<\/b><\/a>\u00a0<\/span><\/p>\n

Seed Stage Businesses<\/h4>\n

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 <\/span>unpriced round, for almost every startup <\/span>the revenues and assets aren\u2019t 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. <\/span><\/p>\n

A convertible note acts as a form of short term debt that converts into an investor\u2019s equity after a conversion event occurs known as a <\/span>conversion trigger.<\/b> For example, when a startup raises a certain amount in its next fundraising round, or another milestone in its lifecycle. <\/span><\/p>\n

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.<\/span><\/p>\n

Thus, investors are able to provide startups with capital in the form of debt<\/strong> through the issuance of a convertible note. This ensures that the investment will convert to shares after the conversion event.<\/span><\/p>\n

Equity Financing<\/h4>\n

The stage of the business\u2019 next financing round is known as <\/span>equity financing.<\/b> 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. <\/span><\/p>\n

If the shares and equity are priced and available for taking, this serves as a <\/span>conversion trigger. <\/b>Whereby the seed investors\u2019 convertible notes automatically turn into equity. The amount of equity that the investor is able to benefit from is determined by the <\/span>purchase price<\/b> given by the investor as capital. This is divided by the <\/span>conversion price, <\/b>which is the investors\u2019 amount given during this priced equity financing round. <\/span><\/p>\n

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<\/a> that will take you through the entire process from negotiations with investors to due payment of the agreed investment amount.<\/span><\/p>\n

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Valuation Caps & Discount Rates<\/h4>\n

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 <\/span>valuation cap <\/b>and <\/span>pricing discount. <\/b>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.<\/span> For more information on valuation caps and discount rates, check out the<\/span>\u00a0<\/span>Shareholder\u2019s Resolution to Issue Convertible Notes <\/b><\/a>template document.\u00a0<\/span><\/p>\n

Pricing Discounts<\/h5>\n

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. <\/span><\/p>\n

Valuation Caps<\/strong><\/h5>\n

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\u2019s valuation, or <\/span>conversion price. <\/b>This\u00a0will be given during the next equity financing round. <\/span><\/p>\n

Here are the best ways for a company and investor to avoid any ambiguities regarding a convertible note.\u00a0 allowing all parties\u00a0 to enter into negotiations and issue shares through convertible notes securely and beneficially:<\/span><\/p>\n