Busting The Myths Behind Convertible Notes
By Rae Steinbach, Updated: 2022-04-07 (published on 2020-04-08)
What You Need to Know About Convertible Notes
Funding is a key issue for early-stage startups. Whereas many small businesses might seek a traditional business loan, this may not be the best option for some startups. If you have a big idea and you want to develop the business quickly, you might try to go after venture capital as a way to fund the early stages of your business.
For early-stage startups looking for seed capital, convertible notes can offer one of the best funding options. Convertible notes have become popular in the world of startup funding because they are simple and flexible while offering benefits to both investors and startup founders. With that being said, they are not a viable option for every business, so you will need to understand what a convertible note is and how they work.
What is a convertible note?
A convertible note is a type of short-term financing used in the early stages of startup funding. With this type of debt financing, the investor gives the startup money, but instead of the principle being paid back in cash with interest, they receive a stake in the company at a later date.
Like a traditional loan, the convertible note will have terms that outline repayment, but the investor usually does not want to be paid back in cash. The idea is that they provide the funding the company needs in the early stages, and the investor can realise more value by getting equity when the startup moves on to its next funding stage. Furthermore, most convertible notes will offer some form of discount when the value of the loan converts to equity.
The Terms of a Convertible Note
Since a convertible note is a type of loan, there will be terms that are similar to that of a traditional business loan. The following are some of the common terms that come with a convertible note:
- Interest Rate: Since the noteholder is not looking to get paid back in cash, the interest rate isn’t as important on a convertible note. That being said, it is a loan and it will need to have an interest rate in case it reaches the maturity date and the noteholder opts to exercise their right to repayment.
- Maturity Date: This is the date that payment is due on the note. If the startup has not moved to the next stage of funding and they have not converted the value to equity, this is the date at which the loan must be repaid.
- Valuation Cap: The valuation cap sets a maximum limit to which the startup can be valued as it concerns the convertible note. Even if the valuation is higher at the next round of funding, the value of the note would convert at the limit set by the cap. This guarantees the investor a certain share in the company regardless of how high the real valuation is.
- Discount Rate: The holder of a convertible note is usually given a discounted rate when compared to new investors who may buy-in during a later round of funding. This is in recognition of the fact that they took a greater risk by providing funding during an earlier stage of the company.
Why use a convertible note?
So why not just hold a round of equity financing and issue shares in the company? There can be significant disadvantages to holding a round of equity financing in the very early stages of a startup.
When a startup is just in the idea stages and has yet to develop, valuation can be a problem. The product might not be fully developed and you have yet to sell anything, so it is hard to determine what the company is worth. Investors are going to want a low valuation and the startup founders are going to want to set it high. The only problem is that you don’t have any data to come to a realistic valuation of the company.
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.
While there are benefits to using a convertible note for early-stage funding, they are not the right choice for every startup. For some businesses, a traditional loan or some other type of financing might be a better option. Take the time to investigate all of the different types of startup funding available before making an agreement on a convertible note.
This article does not constitute legal advice.
The opinions expressed in the column above represent the author’s own.
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READ MORE: The Pros and Cons of Convertible Notes
DOCUMENT: Convertible Note Term Sheet