Convertible Note

Tech startups can have tremendous scale potential and fantastic margins. It is hard to measure how fast they can grow in value and revenue.

It gets to point where you want to raise funding for your startup. In this ecosystem, it is hard for family and friends to put money in a tech startup. Even high net worth individuals are likely to shy away from funding you. You can't really blame them, as this is an area they are not familiar with and don't just know how they will get their return on Investment. As a founder, you are likely to rely on angel investors who are interested in investing in tech.

Tech startups are high scale high margin business and for an angel investor potential and upside is what matters. Assume the investor believes in the company and wants to invest. They will want to put in their money with less negotiation and few legal expenses. This is where the convertible note comes in.

Convertible notes are often used as the first outside funding invested in many companies, and a large number of institutional seed investors exclusively use convertible notes in their accelerator investments.

Convertible Note

A convertible note is a short term debt that converts to equity in a later round of funding or milestone.

The company stock is used as collateral or to repay the debt at a valuation to be decided in the future. It is in the interest of the investor to convert this convertible note to the actual company preferred stock i.e they don't want their loan to be repaid back they want it to convert to equity of a successful valuable company.

Terms of a Convertible Note

  • Intrest rate- the debt earns an interest rate just like any other debt. The interest rates on convertible notes are usually low, between 5% to 7%, as investors are looking to receive equity in your company and not for you to actually have to pay the loan back in cash. The interest rate is not paid in cash but accrued (accumulated).

  • Discount (typically between 10-25%)- After the principal invested and the accrued interest has been summed up to determine how many shares the investor will get they also get an additional discount to the price per share. for example, if the discount stipulated was 25% and the price per share in the priced round is $40 per share the convertible note principal and accrued interest will convert to equity at $30 per share.

  • Max valuation cap - Value at which the investment (principal plus interest) converts to equity. If, for example, the cap were $5 million and the pre-money valuation in the Series A round was $10 million, the amount of the note (plus accrued interest) would convert into shares of preferred stock at an effective price of $5 million. Each investor can get a different cap. The investor wants a lower cap the better the term is for the investor since they will reap bigger if the company increases in value because the buy-in was low.

  • Maturity date - Date on which the convertible note is due and you need to repay your investor their debt.

What triggers the convertible note to convert to equity?

  1. A new round of funding, for example, Series A.

  2. The company gets acquired.

  3. At an agreed-upon maturity date 18 to 24 months.

What happens if you can't repay your loan on the Maturity date?

The goal is to raise a priced round to repay you convertible notes what if things don't go according to plan?

  1. The investor can extend the maturity date of the note. They will likely renegotiate the terms, increase the discount, or lower the cap.

  2. The investor can ask you to repay the loan and to repay it in full principal and interest accrued. If the company can't afford it, it has to file for bankruptcy. This is not in the best interest of the investor as they will have lost their investment while extending the maturity date gives them another shot at recouping their investment.

Advantages of a convertible note.

  1. Speed, simplicity, and cheap in terms of legal expenses. Compared to equity financing round which requires a term sheet and corporate documents such as the certificate of incorporation, shareholder agreement, and voting agreements will have to be edited and signed which could take a long time to get done.

  2. The ability to avoid valuation decision. At this stage, the company has not shown significant traction in the product, users, or revenues. By using a convertible note, you and the investors can determine your valuation at a later time when you have concrete data like growth numbers, sales, and customers.

Disadvantages of a convertible note.

  1. Lack of automatic conversion clause on maturity date- What if the company chooses not or is unable to raise subsequent funding? To avoid the above concerns, the automatic conversion of equity can be agreed upon before the convertible note is signed.

  2. Convertible notes also accrue interest like a loan. This interest is simply added to the equity valuation when being converted during a later investment round. If the interest has not been accurately or fairly calculated, this can result in too large a stake of equity being returned to one investor. Again, this can put off other investors.

  3. Nonalignment of incentives between seed-round investors and company management. The latter want the Series A round to be at as high a valuation as possible, so they dilute their ownership as little as they can. In contrast, seed investors want the next round to be as low as possible so they get the biggest percentage of the company that they can for their investment.

Notes are cheap and easy to do. A good understanding is needed for the different implications of the various potential outcomes. What happens if you do not end up raising additional equity, and also what happens if things go spectacularly well and you are able to raise additional equity far above the valuation cap?

Here is a convertible note template.

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