Posted by Esha Kumar on 29 May 2019
In every startup’s journey, there will be a time when you need to do some capital raising to grow the business.
There are many ways you might source this money.
As you’re considering your options, you’ve probably come across the concept of “convertible notes”. Well, what are they?
In this article, I’ll be breaking down what you need to know about convertible notes so you can decide whether it’s something you want to use to help your startup grow.
Why Should I Use A Convertible Note?
A convertible note is useful when the valuation of your startup is uncertain. As a founder, you’ll obviously want a high valuation, while investors will try and negotiate you down.
Instead of getting bogged down with this negotiation, convertibles allow you to raise money and rely on a more vigorous valuation at a later Series A round.
You can use the initial investment to help your company grow, and when you get to the Series A round, hopefully your valuation is more accurate.
The other advantage of convertible notes is that they are also quick to execute. This is because it is an accepted standard and you generally only need to negotiate a few key clauses.
What Is A Convertible Note?
Basically, a convertible note is a type of capital raising which has elements of both debt and equity.
For more information on the different types of equity financing, have a read of this article: How Does Equity Financing Work?
On a basic level, equity means that investors will get shares in your company, in return for the money they invest.
Debt on the other hand comes with the obligation to pay back the money. The investor (often just called the “lender”) usually gets an interest payment in return.
Now, when I say convertible notes have elements of both debt and equity, it’s basically a loan to begin with, which converts into equity after a certain period of time.
How Does A Convertible Note Work?
An investor who sees potential in your startup might want to invest in your company in return for equity.
In other words, this means giving you money in return for part ownership in your company.
But it can be difficult to raise equity, especially when it comes to valuing your startup.
There are various ways to value a company, but basically it is a reflection of how much your company is worth, or will be worth. However, it’s difficult to know exactly how much a startup will be worth, especially in its early stages.
This is why a convertible note is attractive to many startup owners because the valuation of the company isn’t decided until the debt converts into equity.
In simple terms, this means that you receive cash investment now, but you don’t have to turn it into equity yet.
So, the valuation of your business is delayed and you can use the investment money to help your business grow.
Your investor will then decide a “trigger event” – i.e. when the debt is converted into equity – which is generally when you start you raise your next round.
What Are The Key Terms That Are Negotiated?
One of the key features of a convertible note is that it provides a discount for investors.
The discount will act as a reward for an investor who is taking a high risk in investing in a startup.
A discount will give your investors extra shares in your company when it converts to equity.
The number of extra shares they get will be based on a percentage agreed between you and your investors when drafting up the convertible note.
The valuation cap is the maximum price at which the initial investment will be turned into equity.
If you don’t set a valuation cap with your investors and you end up getting a very high valuation in your Series A, the investor might end up with a tiny percentage of the company.
This is especially the case if your startup grows exponentially and the valuation of your startup is much higher than expected.
However, an investor usually invests in a startup to get a decent return. And this expectation is reasonable given the risk that they’re taking.
And so, to protect themselves from this, most investors will insist on a valuation cap.
If the Series A valuation is higher than the cap, the investor gets to convert their investment into equity under more favourable terms.
What To Take Away…
Thinking about the capital raising options for your new business is important.
You have many choices at your disposal and picking the right one for your company is crucial to its success.
Convertible notes are attractive to investors because of the many options they offer.
Are you considering using a convertible note to help raise funds for your startup?
Or do you need help thinking of alternative ways to raise capital for your business?
Make sure you know how to navigate the conversion terms and details of the agreement between you and your investors!
If you need advice on where to start, feel free to contact us at firstname.lastname@example.org or give us a call at 1800 730 617 – we are here to help!