What is a Convertible Note?
A convertible note is a type of short-term debt that converts into equity, typically in conjunction with a future financing round.
Startups often use convertible notes as a method to raise initial funding. They allow investors to provide capital without having to determine the company’s valuation at the outset. When a company raises additional financing, the convertible note automatically converts into equity at a pre-determined discount or valuation cap.
Benefits of Convertible Notes
Convertible notes provide flexibility, allowing startups to delay valuation discussions. This is particularly advantageous for early-stage companies with uncertain valuations.
For investors, convertible notes offer the potential to convert debt into equity at favorable terms, often with discounts or capped valuations that provide an upside in the event of a successful funding round.
How Convertible Notes Work
Convertible notes start as debt instruments with an interest rate and maturity date. A key feature is the conversion trigger, such as a subsequent equity financing round.
Upon triggering conversion, the note’s principal and any accrued interest convert into equity, based on the terms outlined in the note. Terms often include a discount rate or a valuation cap, benefiting early investors with better pricing than subsequent investors.
Risks Associated with Convertible Notes
While convertible notes offer benefits, they come with risks. For startups, they can lead to dilution if not managed carefully. For investors, the risk lies in the company not reaching a subsequent financing round, leaving the note as debt to be repaid.
Furthermore, the lack of immediate equity ownership can be a downside for investors wanting influence over company decisions from the outset.
Common Questions About Convertible Notes
How does a convertible note differ from a traditional loan?
Unlike traditional loans, which are repaid in cash, convertible notes are structured to convert into equity. This arrangement aligns investor interests with the company’s growth, rather than fixed repayment obligations.
What is a discount rate in convertible notes?
The discount rate is a percentage reduction on the price per share for note holders during conversion. It compensates early investors for taking on more risk by providing them with equity at a lower price than subsequent investors.
What is a valuation cap?
A valuation cap sets the maximum valuation at which the note converts to equity. It ensures that early investors receive a proportional equity stake, even if the company’s valuation significantly increases before conversion.
Can convertible notes include interest?
Yes, convertible notes often accrue interest, which is added to the principal amount during conversion. This compensates investors for the time their funds are tied up as debt before conversion.
Conclusion
Convertible notes offer a streamlined, flexible financing option for startups and investors alike. By converting debt into equity, they provide a way to bridge early-stage funding gaps without immediate valuation pressures.