Convertible notes are a way for seed investors to invest in startups that aren’t yet ready for pre-money valuation.

 

These notes are short-term debt that can be converted to equity in the issuing business. The investors loan money to the startup. They are paid back with equity in the company rather than principal or interest. Once a milestone is reached, the convertible note automatically converts into equity.

 

This is usually when the company has been officially valued for future investments.

 

Takeaways:

  • Convertible notes allow investors to convert their debt into equity in the case of a liquidation or priced financing round.
  • Convertible notes were traditionally a popular instrument for early-stage investing.
  • Convertible notes provide investors with solid protections.

 

 

Looking to level up your VC skills? We’ve got you covered.

 

 

What is a convertible note?

Convertible notes, also known as convertible promissory notes, are short-term debt instruments that convert to equity at a predetermined time.

 

In exchange for equity, investors offer convertible notes to founders. In exchange for equity in the company, investors offer convertible notes to founders. These notes will be converted to equity, which is a stake in the company. This is usually in the form of preferred shares.

 

The basics

Although everyone is aware that investors give money to companies to get more in return, there are many ways that this happens in practice.

 

 

Equity investments

Most people think about an investment when they think of equity. An equity investment is a sale of a portion of a company (equity) for a set amount of money. A company raising funds by selling equity does not have a set repayment schedule.

 

The investor usually expects to make their money back plus a return in a future liquidity event, such as an acquisition or distribution of future profits. Venture capital investments almost always involve an acquisition or IPO as the only way investors make money.

 

Cash flow distributions are rare. Another important aspect of equity investments is that the investor is usually a part owner of the company and has voting rights that can be used to make decisions about the company.

 

Venture capital-backed companies often structure equity investments as preferred stocks. This is different from $X for Y%. The terms of preferred stock usually include a liquidation preference, preferred dividend, and approval rights for certain company decisions.

 

The liquidation preference is a type of preferred stock that allows investors to get their investment back and any preferred dividends before the remainder of the funds are distributed amongst the % owners. Preferential dividends are not paid in cash. Instead, they are accrued and paid when there is liquidity.

 

The founders or employees of the company usually own common stock. This means that all investors must be paid back, plus a guaranteed return (the preferred distributions), before any funds are distributed to common stock. The preferred stockholders have the right to approve items such as terms for future rounds of equity financing or acquisition opportunities.

 

Convertible notes have a few key components:

Conversion discount

The amount at which shares will be given to the investor at maturity or the subsequent ‘qualified funding’ (i.e., The next round of funding.

 

Valuation cap

This is the valuation cap (i.e., Price), the price investors will pay to acquire their equity in the next company fundraise.

 

Interest rate

This interest will be added to the principal amount when debt is converted into equity. To keep the convertible notes’ value primarily on equity conversion, most 2020 convertible notes have a low-interest rate. They also reflect current interest rates.

 

Maturity Date

Convertible notes, like other types of debt, have a maturity date by which investors can request full payment from the company. This data is used to establish expectations for the next round.

 

Why use convertible notes?

Startups use pre-seed funding or seed funding to raise funds.

 

Convertible notes are then used to raise equity capital. Founders can buy shares once they are incorporated at a price stated in the articles. Selling shares at a substantial markup a few months later would be suspicious.

 

This issue is avoided by using a convertible note debt. In the initial stages of a company’s growth, there is often insufficient information to create value. The seed funding is a strong foundation for valuation and will be used to help the company get up and running before moving on to the Series A round.

 

Benefits of convertible notes

Convertible notes enable startups to concentrate on their business rather than having to pay back convertible debt.

 

This is especially important for tech companies that spend a lot of time perfecting their product. Convertible notes make it easy for startups to raise capital. Convertible notes are a more straightforward way to raise money than issuing equity.

 

Investors can see the benefits. If everything goes according to plan, startups with high growth potential can offer a significant return on their investment. Convertible note holders with a low-value cap and steep discounts can offer investors a great way to get equity at bargain-basement rates.

 

Debt investments

A loan with a fixed repayment schedule is the most common type of debt. If the company can make the payments, investors know what they will get in advance.

 

Due to the risk involved in funding this venture, early-stage startups are not likely to use debt. However, some institutional investors provide debt to venture-backed early-stage companies later in their development, especially those with recurring subscriptions such as SaaS.

 

When it comes to debt, there are some essential facts. Unlike equity owners, debt holders don’t have voting rights or ownership of the company. Debt holders have priority in the payment schedule in a liquidation situation.

 

Equity owners are not paid in full, so it’s seen as less risky. A debt deal is less complicated and more expensive than equity because of the paperwork and legal work involved in setting up investments.

 

Convertible notes: A hybrid of equity and debt

Convertible notes, initially structured as debt investments, have a provision that allows principal plus accrued interests to be converted into equity investments later.

 

This allows for the initial investment to be completed faster and with lower legal costs. However, it ultimately gives investors the economic exposure of an equity investment.

Are convertible notes good or bad?

The good

Convertible notes can be used to close a Seed round quickly. Convertible notes are great for quickly closing a Seed round.

 

The bad

If used in an unsafe manner, convertible notes can be dangerous.

 

If you have too many notes or poorly-structured notes, it can be a risk to your company and your future negotiations. It could also complicate your cap table.

 

Before you close a financing round with convertible notes, you should partner with a lawyer familiar with the details. Convertible notes can be a great way to speed up Seed rounds, but you must ensure they are well thought out to avoid any problems later.

 

What happens when a convertible note matures?

Notes also have maturity dates that allow the investor to get their money back (with some interest added) if the financing round doesn’t happen on the due date.

 

Companies have been acquired before their initial equity round, or they choose not to raise equity funding. Both of these are rare but can create difficult situations. Investors aren’t making a high-risk investment to regain their principal and a low-interest rate.

 

Are you required to pay back convertible notes?

Convertible notes work just like any other type of debt.

 

You’ll have to repay the principal and interest. A startup should never have to pay back a convertible loan in cash. This could lead to the company being bankrupt. The startup raised the money to pay for the cash they didn’t have. This risk is greater if a company raises money with multiple convertible notes.

 

This is why neither side wants the convertible note to mature before the next round of funding.

 

How Does a Convertible Note Convert?

A convertible note is converted at the next “qualified financing round.”

 

In most cases, convertible notes will be issued during a seed round. The Series A round is the expected conversion event. It is important to know the terms of the note’s conversion as it can significantly impact dilution.

 

Pre-Money Method

The pre-money Series, a company value, is used to convert the convertible note. In this instance, the founders will pass the dilution to the note holders or new Series A investors.

 

Percent Ownership Method

This method converts the note based on the percentage ownership the Series A investor expects. The founders bear the brunt of all the dilution, which is in the interest of both the convertible note holder and the new investor.

 

Dollars Invested Method

This unique method includes the convertible note’s value in the company’s post-money valuation.

 

The Pre Money Method favors the founder at the expense of investors. However, in the Percent Ownership Method, the founder is more diluted than they expected. The Dollars Invested Method is a middle ground that allows for the dilution amongst Seed investors, Series A investors, and founders.

 

Bottom line

Convertible notes are a great option for the right investors and company.

 

Startups can use the high-risk, high reward model to secure seed funding before they have enough resources to go to Series A funding. Both sides must have a plan in place for every eventuality to maximize the benefits of the arrangement.

 

Companies who aren’t happy giving away equity can look into other options. It is not a good idea to issue convertible notes without considering all options. You may also be able to borrow money from banks, SBA loans or SAFE notes. Consider all options and consider how they could work in different situations before deciding on the right funding source for you company. Startup success is dependent on securing the right funding.

 

To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.

 

Want better VC emails?