If you are a founder of an early-stage startup and you are planning to capture a large chunk of your market as fast as possible, finding and securing external financing is probably your top priority. For many founders, external funding usually equals equity financing when they offer company’s shares in exchange for an external source of money. Although still most common equity financing is not the only form of financing available to startups - another, very interesting alternative is a convertible note which offers additional flexibility for companies raising capital.
Early-stage startups struggle with limited traction, non-existing or limited revenues and difficulties with right company valuation which makes the negotiations with conventional lenders long-lasting and ineffective. In such a case, convertible note is a perfect solution, as it significantly accelerates the pace of closing a deal with investors and enables early-stage startups with no obvious valuation to obtain financing - often in a much cheaper and faster way than equity. Thanks to that, founders can fuel their startups’ growth and they don’t need a bank loan which is almost impossible to get anyways.
What is a convertible note?
A convertible note is a type of short-term debt financing with repayment terms determined, popular within early-stage capital raising. Along with cash infusion, investors give a startup the vote of confidence and if the startup succeeds, it is obliged to convert the loan into shares at a premium discount. To put it simply, it’s a loan for a startup from early-round investors who offer it with the expectation that at some point in the future (usually upon closing of a Series A investment round) instead of being paid back with interest, the debt will convert into the company’s shares.
How does a convertible note work?
An investor provides a startup with a loan under certain repayment terms – i.e. valuation cap, discount rate, interest rate and maturity date. However, unlike an ordinary loan, when the due date comes, the investor gets his loan and accrued interest repaid not in cash but in the company’s equity. Typically a conversion is triggered by an equity round.
If there was no equity round until the maturity date and the business has not converted the loan, the investor has a choice to extend the due date of the repayment or call for the actual repayment.
Last but not least, if the note matures and does not convert, it is very likely that the business will not have what it takes to pay back the loan. That is why in order to find a middle ground between the interests of a company and its investors, very often an automatic conversion price is set. It is a value at which the note converts at maturity, provided that no equity financing took place beforehand.
Convertible note terms your startup should be familiar with
Convertible note just like a traditional loan should be issued under some terms and there are few key parameters that every founder should be aware of:
Maturity date
It is a date indicating when the loan is due and then the startup needs to either repay it or by this time raise a funding round.
Interest rate
Convertible note interest rate is much lower than for a traditional loan as it is only a kind of insurance for the investors in case they decide to have their money back paid in cash instead of receiving equity, which happens rarely. These interests usually accrue as additional principal increasing the number of shares.
Discount rate
The discount rate or short discount is a reward reserved for investors for believing in your business early on in the game. It allows the debtholders to convert their notes at a discount of the equity valuation for the equity round or in other words to obtain shares in the business at a lower price than the price paid by equity round investors.
Valuation cap
The valuation cap is another reward for early-stage investors. It sets the maximum value of the company at which the debt converts into equity.
For example, if during the equity round the company is valued at 10M EUR and the valuation cap was set at 7M EUR the note conversion will be executed at 7M EUR, giving a sizable reward to the early investor. At this point, it is important to notice that valuation cap and discount are not used together. It’s either one or the other, meaning that investors use the discount only if it gives them a better conversion price than the valuation cap. For instance, let’s analyze a convertible note with the following parameters – valuation cap 10M EUR and discount 20%. If the next founding round happens and the company is valued at 9M EUR the note conversion will not be based on the valuation cap since it’s higher than the actual value of the company, but on the 20% discount (7.2M EUR).
Advantages and disadvantages convertible notes as a form of fundraising
Advantages
- Simplicity – typically an equity round requires updates to a plethora of corporate documents, which in most cases requires time and drives expenses. Convertible notes do not need that, they are usually much simpler in their form and quicker to proceed. Moreover, very often, they push settlement on trickier arrangements between investors and companies to the future.
- Delayed valuation – convertible notes allow founders to delay the valuation of their startups. This may be a very interesting option for early-stage startups with little or no traction as it enables them to preserve equity and preserve them from giving away too much stake in the business to early investors.
- Potentially lower cost of debt – in general, due to very high level of associated risk, early-stage startups are unbankable, and if by any chance they manage to secure a bank loan, because the capital donor needs to off-set all the risks, its terms are prohibitive (expensive, overcoratelarised, etc.). Convertible note investors have a bit different optics. Since their compensation for taking the risk is secured in the equity upside, they are usually fine with offering the capital at the lower interest rate. Moreover, the interest associated with the convertible note is usually not paid in cash but added to the principal and converted to equity when the right time comes. This means that founders do not need to worry about regular payments and have a better cash flow situation.
- Flexibility – startups often need to secure some financing between larger equity rounds and some characteristics of convertible notes are very useful in such situations.
Disadvantages
While convertible notes systematically gain popularity, startups and investors need to consider potential future implications and disadvantages of such a source of financing.
- Valuation – although convertible notes delay putting a price on the company, many of them include a valuation cap and an automatic conversion price, which acts as an anchor for valuation discussion during an equity round.
- Risk of not raising an equity round – if the note matures and does not convert it is very likely that the business will not have what it takes to pay back the loan. This of course is a very uncomfortable situation for a startup and its investors and has many negative implications for both parties. That is why it is important to establish a plan for such eventuality early on.
- Giving away equity – although convertible notes are similar to debt, it is still a commitment to give up some equity shares at some point in the future.
Is a convertible note right for your startup?
Convertible notes are a hybrid of equity and debt financing and as such are characterized by many of their advantages. This is also one of the reasons why they are quite common among early-stage startups. However, they may also have a serious impact on your business in the future – especially if things do not go as planned. Therefore, before deciding to use this financial instrument, make sure to understand all potential outcomes.
Useful to know
Several renowned investors made efforts to standardize convertible notes and put together templates. The two most popular ones are:
- the developed by Y-combinator SAFE (Simple Agreement for Future Equity) framework,
- the developed by 500 startups KISS (Keep It Simple Security) framework.
However, founders should remember that both frameworks were developed under US legislation and that some provisions should be conditioned/adjusted to local regulations.
Another useful framework - which is not a convertible note but incorporates a discount - is an Advanced Subscription Agreement (ASA). When investing under ASA, investors agree to pre-pay for shares issued in a subsequent equity round at discount. In contrast to a standard convertible note, cash invested via ASA cannot be paid back.
Related Posts:
Overview Of Top Funding Sources To Grow Your Startup (by Kaja Dubielska, Vestbee)
Types Of Startup Funding Rounds (by Marcin Laczynski, Partner, Next Road Ventures)
What Is A Broken Cap Table And How A Startup Can Fix It? (by Ales Duchac, Credo Ventures)
