How does convertible note work as a funding instrument?
A convertible note work is extremely important for a startup business to understand as it is a way for startups to take on short-term debt that is able to provide long-term value to them. So how does one use the convertible note to grow the business? In this article, we will be looking at how convertible notes work as a funding instrument, what are the pros and cons of having it, and what it takes to make convertible notes good for a startup.
What are Convertible Notes?
A convertible note allows seed investors to invest in a firm that has not yet been valued. They begin as short-term debt and eventually become stock in the issuing company. Investors make loans to startups in exchange for stock in the company rather than capital and interest. When a specified milestone is reached, such as when the company is formally appraised for future investments, the convertible note is immediately converted into equity.
Why Do Startups Use Convertible Notes?
Convertible notes are used by startups that require pre-seed or seed investment before offering equity funding. Because founders can buy their shares at a price stipulated in the articles of incorporation, selling shares at a high markup a few months later might appear suspect.
To avoid this problem, convertible notes are employed. In the early phases, there is frequently insufficient evidence to determine a valuation of the company. Using seed funding to get the company started provides a stronger platform for valuation before the Series A fundraising round.
Benefits of Convertible Notes
Convertible notes allow startups to focus on expanding their businesses before having to begin repaying debt. This is especially crucial for tech companies that must spend a significant amount of time fine-tuning their product. Convertible notes are a simple and quick way for entrepreneurs to raise capital. Issuing equity is a more involved process in which convertible notes are avoided by using debt.
The advantages for investors are obvious. When everything goes well, startup enterprises with significant growth potential provide an outsized return on investment. Investors can end up with a lot of equity at bargain-basement prices, especially with convertible notes with a low-value cap and a severe discount.
How does Convertible Note Work?
Convertible notes are typically attractive to investors who believe the company will grow rapidly. In the end, they believe the startup’s stock will be worth more than the interest on the debt. The loan and repayment terms, as well as the following, are included in convertible notes:
Valuation cap
The value cap sets a maximum price for investors to pay for their equity in the next fundraising cycle. Lower ones help investors since they give them a larger stake in the company. For example, if the company is worth $10 million but the valuation cap is $1 million, a $100,000 investment would result in a 10% stake in the company rather than a 1% stake.
Interest rates
Because convertible notes are a loan, they have an interest rate. The distinction is that convertible notes pay interest in the form of equity rather than cash. When the note is converted, the interest rate is the amount that is added to the principal amount. Because the value is mostly in the equity conversion, interest rates are often low and in line with current rates.
Conversion discount rate
This is the share discount rate that the investor will get when the note matures. This rewards investors for the risk they took by participating so early in the process. They have the ability to purchase more shares with their investment than investors in later rounds of buy-in. If the discount is 30% and the shares are sold for $1 per share in a later round of investing, the investor’s equity will be priced at 70 cents per share.
Maturity date
This is the day on which the investor can request full repayment from the company or request that the note be extended.
Why some startups would not recommend using a convertible note?
While convertible notes have many advantages, they can also have substantial disadvantages for both entrepreneurs and investors. These are some examples:
Failure to secure future financing
There is always the risk that the company will be unable to attract equity financing in subsequent stages. If the note expires and the company is unable to obtain further capital, it is doubtful that the note will be repaid. A convertible note default can force a corporation into bankruptcy.
However, if an investor forecloses on a business, they almost certainly guarantee a total loss on their investment. Both parties are losing in this circumstance. Before investing in a convertible note, investors and companies should consider all options, including failure.
Diluting shares of the company
The major downside of convertible notes for businesses is that they give away future equity that has the potential to be significantly more valuable than the original borrowing. This is especially true for low valuation caps. If a startup experiences tremendous and unexpected growth in its early phases, it may be forced to give away a considerable portion of its equity.
Time-consuming process
Convertible notes are significantly less complicated than Series A fundraising, but they can still be complicated and time-consuming to manage. Before the agreements are formalized, they must be worked out by lawyers and handed back and forth between investors, founders, and their lawyers.
How to determine whether the convertible note is good for your startup?
Seed capital in the form of convertible notes can help early-stage firms that are on track to grow swiftly. However, having a clear path toward value is critical so that the conversion isn’t an issue when the company is ready for another round of funding. Convertible notes can also be used by businesses that need to obtain funds in between larger stock rounds.
Companies that are hesitant to give away too much equity can look into other solutions. It’s never a good idea to issue convertible notes without first considering all of your possibilities. SBA loans, SAFE notes, KISS notes, grants, bank loans, or lines of credit are all available financial options.
Before determining which is the greatest fit for your firm, consider all of the options and how they will play out in different scenarios, both positively and adversely. Obtaining the appropriate capital is critical to the success of any startup.
Reach out to Eqvista for a discussion
If you’re unsure of how to proceed with convertible notes or how the process would be, reach out to our experts for a quick discussion. It can be challenging to figure out how much of a company’s stock you actually hold based on your convertible notes. Eqvista’s convertible note calculator is here to help.
