In the early days of a startup, the business will often require funding but may not be ready to do a straight equity round of funding. A great solution to this can be to issue convertible notes to your investors. In this article, we’ll cover what a convertible note is and the ramifications of using one.
What are Convertible Notes?
There are various ways to raise capital for a startup. The most well-known is issuing shares, but this can be problematic if the company has not yet been valued. A convertible note is an instrument whereby the noteholder has the option to convert it to equity later on and acts as a loan (debt) to the startup. Instead of an investor receiving equity straight away, they can convert their notes to shares later on, usually at an agreement time period or ‘trigger’ event. Convertible notes are most common in early stage investing rounds.
Convertible notes can be a great way for a startup to raise capital early on before they’re ready to value their shares. Some added benefits of using a convertible note are:
1. It’s fast and easy to create
A startup can arrange a convertible note within a day or two. It does not require the same amount of due diligence as if a startup intends to issue shares immediately. Further, a convertible note is not itself a complicated document and can be drafted quickly.
2. It can be used early on
In a startup’s early days, it can be difficult to value your startup. With no or little revenue it might be hard to calculate a valuation using a revenue multiple or other valuation method. A convertible note allows for no valuation or share price to be set, instead a discount or coupon can be used on the note. This discount or coupon is that converted at a later date into equity, typically at the next round of funding.
Put simply, convertible notes preclude the need for a valuation, since they are loans which are paid back in equity later on. The startup subsequently can reap the benefits of the loan and use the funds to grow the business.
3. There’s no Dilution
A convertible note converts into shares when triggered by a certain event, often a funding round, exit event or time period. As a result, issuing convertible notes does not dilute existing equity ownership as shares are not issued upfront. This allows startup owners to still retain control of their company whilst receiving funding. This may also result in tax advantages.
1. It can be risky
Because you may be investing in a startup that has little to no earnings, you are exposed to more risks in your investment. Some investors prefer to wait until the startup reaches the funding rounds to invest. They do this knowing that they would be paying a more premium price.
2. There’s less control
A convertible note does not come with control rights. This includes board seat, veto rights, and rights to participate in company actions. However, issuers of the convertible note will see this as an advantage as it can get funding without giving rights towards the lenders.
Issuing convertible notes is a popular way of receiving funding by early stage startups. This is because of its hybrid nature, where it is designed as a debt and converted to equity later on. Although it is frequently used during the seed rounding stages, you may issue convertible notes later on during a startup’s life cycle. If you’re considering investing this way, it may be worth consulting a business lawyer for more information.