Convertible Note - definition & overview

A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. In essence, the investor loans money to a start-up and instead of a return in the form of principal plus interest, the investor would receive equity in the company.

The primary advantage of issuing convertible notes is that it does not force the issuer and investors to determine the value of the company when there really might not be much to base a valuation on - in many cases the company may just be a concept. This method is used as a means to fund a small business until it can get to a place or time where it has grown enough to warrant a formal valuation.

Understanding Convertible Notes

Convertible notes are a popular choice for early-stage start-ups that wish to raise capital but are not yet ready to establish a valuation. They are often used as a bridge between self-funding or seed funding and a Series A round of financing.

Convertible notes are essentially loans, but the difference lies in how they are paid back. Instead of being paid back with cash, they are paid back with equity in the company. This means that the investor will own a portion of the company, rather than receiving their investment back with interest.

Key Features of Convertible Notes

Convertible notes have several key features that distinguish them from other forms of financing. These include the principal amount, the interest rate, the maturity date, the conversion discount, and the valuation cap.

The principal amount is the initial amount of money that the investor lends to the start-up. The interest rate is the percentage of the principal amount that accrues over time until the note is converted or repaid. The maturity date is the date by which the note must be converted or repaid.

Benefits of Convertible Notes

Convertible notes offer several benefits to both the investor and the start-up. For the investor, they offer the potential for a high return on investment if the start-up is successful. They also provide the investor with some protection, as they will receive equity in the company if it fails.

For the start-up, convertible notes offer a quick and relatively easy way to raise capital without having to give up a significant amount of equity. They also allow the start-up to delay establishing a valuation, which can be beneficial if the start-up is still in the early stages of development.

How Convertible Notes Work

When an investor invests in a start-up using a convertible note, they are essentially lending money to the start-up with the expectation that the loan will be paid back with interest. However, instead of being paid back in cash, the loan is paid back in the form of equity in the start-up.

The conversion of the note into equity typically occurs during a subsequent round of financing, known as a qualified financing round. The terms of the conversion, including the conversion rate and the valuation cap, are typically specified in the convertible note agreement.

Conversion Mechanism

The conversion of a convertible note into equity is typically triggered by a qualified financing event. This is usually a subsequent round of financing in which the start-up raises a certain amount of capital. The convertible note will specify the minimum amount of capital that must be raised in order for the conversion to be triggered.

Once the conversion is triggered, the principal amount of the note, plus any accrued interest, is converted into equity at a pre-determined conversion rate. This rate is typically a discount to the price per share paid by the investors in the qualified financing round.

Valuation Cap

A valuation cap is a feature of a convertible note that protects the investor in the event that the start-up's valuation increases significantly before the note is converted. The valuation cap sets a maximum valuation at which the note can be converted, regardless of the start-up's actual valuation at the time of conversion.

If the start-up's valuation at the time of conversion is higher than the valuation cap, the investor will receive more shares than they would have without the cap. This is because the conversion rate will be based on the valuation cap, rather than the actual valuation.

Convertible Note vs. Equity

Convertible notes and equity are two different ways for start-ups to raise capital. While both methods involve giving the investor a stake in the company, there are key differences between the two.

With equity financing, the start-up sells a portion of its equity to the investor in exchange for capital. The investor becomes a part-owner of the company and has a claim on its future profits. However, determining a fair price for the equity can be difficult, especially for early-stage start-ups.

Advantages of Convertible Notes

Convertible notes offer several advantages over equity financing. First, they allow the start-up to raise capital without having to establish a valuation. This can be beneficial for early-stage start-ups that may not have a clear idea of their company's worth.

Second, convertible notes are generally quicker and less expensive to issue than equity. This is because they do not require the same level of due diligence and legal documentation as equity financing.

Disadvantages of Convertible Notes

Despite their advantages, convertible notes also have some disadvantages. One of the main disadvantages is the risk of dilution. When the note is converted into equity, the start-up's existing shareholders will own a smaller percentage of the company.

Another disadvantage is the potential for conflict between the start-up and the investor. If the start-up's valuation at the time of conversion is lower than expected, the investor may end up with a larger stake in the company than they had anticipated.

Conclusion

Convertible notes are a versatile and popular tool for start-ups looking to raise capital. They offer several advantages over traditional equity financing, including the ability to delay establishing a valuation and the potential for a high return on investment for the investor.

However, like any form of financing, convertible notes also come with risks and disadvantages. It's important for both start-ups and investors to fully understand the terms of a convertible note agreement before entering into one.