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What Are Convertible Notes?

Convertible notes are short term debt instruments that can be converted into equity at a later date. When a convertible note is issued, an investor loans money to a startup as a traditional debt lender would, but instead of receiving principle and interest payments, the investor gets company equity in the form of preferred stock. This “conversion” event usually occurs during a future funding round. Convertible notes are typically issued during the seed stage in a startups life cycle to investors that want to get in before a valuation is established.

Why Companies Use Convertible Notes

Convertible notes offer quite a few advantages to young startups in their seed stage. This is because many startups tend to be pre-revenue and do not have adequate assets to calculate a serious valuation. Convertible notes help push the issue of valuation down the line while allowing investors to get in and startups to maintain control. The main advantages of convertible notes are:

Valuation Delay: Unlike a typical equity financing round, convertible notes do not assume the valuation of the company that issues them. Instead, valuation is established in a future funding round where more information is available. Convertible notes are also easier to issue than traditional common stock due to reduced legal costs and a more expedited procedure.

Control: Investors that give startups a lot of money typically want some control to come along with their equity. This can sometimes cause friction between founders and investors when differences arise on how to run the company. However, convertible notes do not grant investors any power. Only when notes are converted, and investors receive preferred stock are they granted rights that may include voting, board seats, the power to veto, etc.

Speed & Cost: Convertible note funding rounds can be closed in days with minimal paperwork and very modest legal fees. This is quite different from equity funding rounds, which not only take weeks but often cost tens of thousands in closing and legal feed alone.

Investor Round-Up: Convertible notes allow startups to herd prospective investors. They allow for variable pricing, which helps startups get the best possible deal by allowing them to give different prices to different investors. This prevents the deadlock, which is a common symptom of the “herd” mentality investors may have when waiting to see who else is going to invest before committing their capital.

Terms of Convertible Notes

After issuing convertible debt, investors look forward to a startup's next equity funding round. How much equity the investor gets upon this conversion event depends on the pricing discount and valuation cap and dividing the purchase price by the convertible price. The parts of a convertible note are:

Discount Rate: The discounted valuation that holders receive in relation to future financing rounds as a premium for the additional risk of being first. When a subsequent funding round is raised, early investors get their shares at a discounted price (usually around 20%) while later investors pay a premium.

Valuation Cap: The price limit at which the convertible notes can be converted into equity. Holders usually also receive protection to the extent the company raises its next round at a valuation that exceeds the valuation cap. The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations, and notes are cheap and easy to do. Thus, if you wanted, you could have a separate note with a different cap for each investor.Interest Rate: Since convertible notes start as debt instruments, there is usually an outstanding interest rate that accrues over time. However, the total sum of this accumulated interest rate is paid back in the form of shares issued during conversion from a financing round. Maturity Date: The date that the note is due and a company must either repay the note or raise capital.

Common Stock vs. Preferred Stock

Common stock is often issued to incubators and friends or family by startups. However, many angels and venture firms will not accept it. This is especially true when convertible notes are issued because preferred stock comes with certain rights and privileges that common stock does that. Some are:

  • Common stock runs the risk of dilution during valuation negotiations in a future financing round
  • Tax issues can arise when investors pay more for their common stock than the original nominal price during the origination of the shares by founders. In such cases, a taxable event may occur, as this may be seen as a form of compensation to founders.
  • Problems with granting stock options may also arise because of the underlying value of the common stock, also known as the "strike price," would have been established. This is contrary to the goal of convertible notes, which are meant to delay valuation. Furthermore, employee stock options, which priced to incentivize employees to stay with a company as long as possible, would also be affected.

It's no easy feat to value a seed-stage startup and negotiate a valuation when a working product may not even exist yet. Such uncertainty could lead to a startup not being able to get the vital capital it needs to survive until its first equity funding round. Therefore, convertible notes offer a helping hand by delaying the valuation process until sufficient data is available. The ease and simplicity with which these notes can be issued make them very attractive to investors and startups. The minimal legal work, short origination time, and attractive terms reduce the burden on both parties and are why convertible notes are a staple in the startup financing world.

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