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A convertible note is a financial document used to close a loan with a nontraditional lender, such as an angel investor or venture capitalist. A company owner may get capital in return for short-term debt by using a convertible note. Unlike a business loan, where the short-term debt is returned and fulfilled, a convertible note gives the investor the option to convert the debt into preferred shares in the borrowing firm at a certain date or event.
A convertible note, for example, maybe used by a borrowing firm to get $100,000 in investment from an angel investor. Instead of repaying the debt in cash, the borrowing company will give the investor shares of ownership in the company equal to the amount borrowed plus interest. If there is a discount rate, the investor will pay a lower price for his or her shares. This reward will be made at the maturity date or at a subsequent round of fundraising valuation.
What Is a Convertible Note and How Does It Work?
A convertible note, like a promissory note, is used to establish a financial arrangement. It takes the shape of a regular loan with typical conditions of repayment. The loan is normally for a brief period of time, with repayment taking place within a year or two. Unlike a promissory note, where the corporation repays the borrowed funds, a convertible note pays the investor with stock in the company. This happens at a certain time or occasion, such as a new round of financing.
If an investor did not want to be repaid in money and instead desired reduced ownership in a quickly developing firm, they would pick a convertible note over a promissory note.
The following are the contents of a convertible note:
- Interest rate: This is a percentage of the money invested that is paid out as interest. The percentages will vary, but 10% to 20% is the usual range. An investor who invests $100,000 may get $110,000 after a year if the interest rate is 10%.
- Discount rate: This enables investors to buy stock at a lower price than its face value, usually 10% to 20% less. The per-share value of a company with a $1 million valuation and 1 million shares is $1. Without a discount, a $100,000 convertible note would be 100,000 shares. The share price is decreased to 90 cents upon conversion due to a 10% discount, giving the investor 111,111 shares.
- The valuation cap; is the maximum financial number that may be attributed to a company’s worth. A $2 million business with 2 million shares has a per-share value of $1. A $100,000 convertible note with a $1 million value limit would convert at 50 cents per share, resulting in 200,000 shares for the holder.
Examples of Convertible Notes
The terms and conditions of a convertible note may be quite varied. Five of the most frequent words found in a convertible note are listed below. In our scenario, a fledgling company raises $100,000 with no maturity date and is valued at $2 million, or $1 per share, after a year.
The starting firm in each of the five scenarios in the table receives just $100,000. The startup’s cost of fundraising shows how costly it is for them to employ those terms. The cost of financing rises as you travel down the chart, making the conditions more financially advantageous to the investor. When seeking angel or venture capital investment, both new firm founders and investors should keep this chart in mind.
Who Should Use a Convertible Note?
A convertible note will be used by startup firm owners and investors when:
- Convertible notes may help company owners finance expansion efforts such as marketing, recruiting, and product development.
- Creating a minimal viable product (MVP): A minimum viable product (MVP) is a product that has been sufficiently developed to satisfy early investors. First-time entrepreneurs may have difficulty securing this form of funding, but company owners who have had past success may be able to attract investors provided they have a minimum viable product (MVP).
- Avoiding a value: This enables a business to raise early capital without having to obtain a valuation by issuing convertible notes.
- Bridging the gap between two fundraising rounds: If a venture capital round is postponed, a lesser round of funding may be used instead. A convertible note may be used for this, albeit it’s not the most typical use.
Alternatives to Convertible Notes
Before settling on a convertible note, it’s a good idea to look at other financing choices and closing papers that aren’t convertible notes, and then figure out what’s ideal for your company.
Alternative Sources of Funding
- Microloans from the Small Business Administration (SBA): SBA microloans range from $5,000 to $50,000 and are available for short-term funding. Although the typical microloan is less than $15,000, an SBA loan may be less costly than giving up equity in your business.
- Grants: Entrepreneurs may seek grants from the federal, state, and municipal governments, as well as nonprofit organizations. Competition for grant money is fierce, but so is competition for angel and venture capital funds. Grant amounts and requirements can vary.
Alternative Documents for Closing
- The Y Combinator-created Simple Agreement for Future Equity (SAFE): Combines the flexibility of convertible notes with the debt component. A SAFE has no maturity date or interest rate, making it a straightforward agreement with no time constraint on development.
- Keep it simple security (KISS): A KISS is similar to a convertible note but contains both a debt and equity form. It was designed by 500 Startups. It includes provisions and triggers for a firm sale, minimum investment rounds, and transfer rights. Consult your legal advisor before employing a KISS to ensure that you completely comprehend the document.
Pros and Cons of Convertible Notes
Convertible notes provide the following advantages:
- There are no recurring costs: Convertible notes enable you to get financing for your company without having to make monthly payments like you would with a small business loan. This helps to maintain a healthy short-term cash flow.
- Flexible terms: Convertible notes do not have the same strict conditions as loans. The terms of the agreement between the new firm owner and the investor are negotiable.
- Investor and startup interests are aligned: Because the investor receives stock in your firm as part of the convertible note, both you and the investor have an incentive to see your company thrive rapidly.
Convertible notes have the following disadvantages:
- Finding investors is difficult: Angel investor funding is very competitive, so even having a terrific product with tremendous growth potential may not be enough to get finance.
- Loan conditions are tighter; than other loans, but they are also quite transparent. Money is lent and then repaid. It might be difficult to assess the influence of interest rates, discount rates, values, and maturity dates. Any convertible notes should have your financial adviser significantly engaged.
- Convertible notes dilution equity: You’re giving up a piece of your firm when you take out a convertible note, and the worth of that lost equity is difficult to determine. This may also present issues with decision-making, since owners and investors may have opposing viewpoints on a company’s future direction.
Conclusion
Convertible notes enable your firm to obtain funds from angel investors or venture capitalists in return for stock in the business. It allows you to raise money without having to make the monthly payments that come with a startup loan.
The methods for writing a convertible note are more adjustable and flexible than securing a small company loan after you’ve found an investor eager to join you. Convertible notes, on the other hand, are sophisticated and should only be done with the help of a financial professional. Before committing to a convertible note, consider all other possibilities for startup capital.
Frequently Asked Questions
Is a convertible note debt or equity?
A convertible note is a debt instrument that can be converted to equity.
How do you classify convertible notes?
A convertible note is all the same until it’s converted into a fixed-rate loan.
