Convertible Note: How do they work?

As a founder, you need to raise money to give reins to your business, and perhaps among the options you have heard on the internet, you have come across convertible notes.

From the beginning, this fundraising option promises to be fast and efficient when building capital for your first steps, but what is it about, and how does it work?

Well, we are going to decipher all these doubts within this article.

Please continue reading. 

CodeDesign is the leading digital marketing agency in Lisbon Portugal.

What is a Convertible Note?

If your startup is ready to start seeking funding but has yet to establish an established valuation, opting for a convertible note may be the most suitable option for you. 

This process consists of receiving a loan that you will later pay in the form of equity. In other words, you will not repay this loan in dollars with interest. Instead, give a part of your company's stock to the lender once your business reaches the established milestone or is ready for second fundraising. Read this complete guide on digital marketing funnel and then choose the right digital marketing channel for your business.

Convertible notes are an excellent option for you because:

• They are a simple and fast solution
• Lawyers and investors are familiar with it
• It helps you delay valuation until the subsequent financing round

Why do Startups Use Convertible Notes?

In the first instance, the reason is apparent. Startups look for this debt instrument to be able to grow their business in the first states and then open their horizons to new forms of fundraising for their company.

Even so, the convertible note has another series of benefits that make this option more attractive for startups, among them we have.

Flexibility.

Unlike other traditional debt instruments, which have fixed terms and interest rates, these notes give you a more accessible range of negotiation with investors in which both can agree on the terms of the loan, including the interest rate, conversion price, expiration date, so that it is beneficial for both parties.

Speed.

Unlike equity financing, which can involve complex legal and regulatory processes, convertible notes are often traded on faster and less cumbersome terms. This characteristic benefits all startups that need to raise funds quickly.

Delayed

This debt tool allows you to convert notes into equity for a later date. This benefit is also suitable for investors since they can work together to support the company's growth without buying shares. If the company's stock rises, the investor can convert the note into shares at a discounted price, potentially earning a profit.

How do Convertible Notes Work?

Many startups want to go with a convertible note because they are so early in their process and have no idea of their company's value on the market or even how much the shares they will offer as equity would be worth. Even this startup may be an idea when opting for one of these notes, and with the help of this loan, you will give value to the startup in the future. Check these Amazon FBA tips to grow your business and see how optimising your Amazon listing could help you grow. 

So, in summary, the convertible note is a loan that will be paid in due time in the form of equity from your company to the lender. The maturity date is usually exposed in the contracts, and once the goal is reached, the investor will obtain part of your stock as a payment method, adding an interest that both parties will establish in the first phases of negotiation. This process differentiates it from a traditional loan, where you must pay the value in dollars plus added interest.

Now, in writing, it may sound easy, but let's say that this process takes several steps to complete:

1. Find an investor who is willing to invest through a note.
2. You and the investor discuss the note's terms, mainly a discount rate and a cap.
3. It is advisable to meet with a lawyer and other financial advisors to create the contract for the convertible note.
4. Investors approve the note.
5. They deliver the money.
6. You take care of building your startup with that loan.
7. After a while - and if things have gone well - you find investors to do an equity round and agree on terms for the 'qualifying financing round' in which the note converts from debt into shares.
8. At this time, your first investors get shares or equity in the company, usually on the same terms as the new investors, and then both become part of your cap table.
9. The convertible note has already been settled for this part; you can eliminate it.

To illustrate it better, let's give an example of how a convertible note works:

So, suppose an investor gives you $100,000 on a convertible note. Great, that's a good start.

This $100,000 will come with a 15% interest rate and a maturity period of 1 year.

What does this mean?

Well, this means that after one year, you will have to pay that note plus that 15%, being $115,000.

Making a jump in time, we assume that you have grown enough as a startup throughout this year. You've done so well that you feel ready for another funding round, like a series A fundraiser. This series A fundraising is a price round that will finally allow you to value your company at a specific price.

So, now that you know how much your entire company is worth, you will also learn how much a share of it will be worth. It is at this time that you can now pay your original investor.

For this, you will have to give him the original $100,000 plus 15% interest, all this in the value of shares of your company.

Warning: It is good to note that these notes can represent a risk for your startup if you do not take advantage of them properly.

Remember that at the beginning of this negotiation, a maturity date will be imposed that you must fully comply with. If you do not manage to have a well-established price or reach the second fundraising by said date, this breach could lead to problems or even bankruptcy for your company.

The term can be renegotiated and extended on certain occasions, but we recommend using the resources they give you. Read this guide on E-commerce supply chain and voice search optimization.

Convertible Note Terms.

With this in mind, there are specific terms that you should know when applying for a convertible note, and these are the following:

Discount Rate

This percentage refers to the investor's price for the loan conversion. This factor is the one that most motivate them to make the loan since, as a benefit, they end up paying a lower price than other investors in the subsequent equity round. So, if the discount is 20% and shares are sold for $1 per share during a later investing round, the investor's stock will be priced at 80 cents per share.

Valuation Cap.

This factor refers to the pre-money amount the loan converts to equity. This factor is especially important for investors since it gives them the security that their investment will convert into equity at a beneficial valuation. If your company is worth $10 million and the valuation cap is $1 million, the $100,000 investment would be 10%, not just 1%.

Interest Rate.

This interest refers to what the investor will receive in exchange for his loan. However, unlike other loan methods, this is lower since the investor takes on additional risk by loaning a startup. This rate is the one we exemplify above with the 15% interest rate, which is usually established in the negotiation stages.

Maturity Date.

This term is the deadline by which you must repay the debt or convert it into equity. These terms are usually between 1 year to 18 months.

Benefits of Convertible Notes

At first glance, we can see that the benefits of convertible notes over other loan options are their speed, simplicity and that they can be repaid in the long term with equity. However, we are going to expand these benefits further in this section.

Simpler Legal Procedures.

Paperwork and legal procedures are something necessary, but at the same time, so annoying. We understand; we all wish we could give you a "skip intro" to this part of the negotiations, but even so, you know that it is essential so that there are no legal loopholes in these negotiations.

Luckily the documents referring to these notes are much simpler. For the most part, these are usually templates in which the lawyers only add some numbers and names. In general, all these details come together quickly, leaving everything to do with equity deals for last.

It's Cheaper than Equity Funding Rounds

It is good to point out that convertible notes require fewer expenses than a round of venture capital prices; since their documents are uncomplicated, you will not have to spend a lot of energy and money to renew said contracts. A round of equity financing consists of many more documents, such as certificates of incorporation, operating agreements, shareholder agreements, and voting agreements, among others. So compare the scale and see how much you will be saving in lawyer fees. It's quite a lot!

Delay Pricing Discussion

Many startups choose convertible notes since these give them a chance to delay the valuation of their company since, in the beginning, they have not demonstrated much progress in product development or revenue. When they give investors a discounted price for future equity, startups can push the valuation decision later.

Disadvantages of Convertible Notes

Since we have seen the benefits, you can opt for a convertible note now, but wait since any loan comes with some cons that we should analyze. Therefore, to help you make the final decision, it is good to look at these notes' disadvantages.

Some Investors don't like to invest in Convertible Notes.

It's sad to admit, but many investors out there are not willing to invest in convertible notes. The main reason: they don't know how much they can earn from this deal.

Failure to Secure Future Financing

In the business world, you must be clear that there is an opportunity to fail. Is it 50%? 20%? We don't know, but like everything in life, it is a possibility.

This risk is another reason why many investors refrain from convertible notes because if, at maturity, the startup doesn't make a profit, the investor won't recover their money, and if your business is in a precarious situation, you will probably not be able to pay this debt.

 Therefore, the worst scenario looms bankruptcy.

Whatever the case, most negotiations of this type usually propose a plan between the founders and the investors so that they can achieve all the proposed goals, so it is always better to have a well-stipulated plan before starting the process.

Giving Away Shares of Equity

Many startups don't like equity as a negotiation term because they could give a considerable part of "the cake" that could be more valuable than the original loan. This scenario is more often when the valuation cap is low. So, if you face the best-case system and your startup faces notorious growth, you would give up a large percentage of your equity, resulting in a bittersweet feeling.

Final Thoughts.

Any startup in its first steps, or even if you only have the idea of one, could benefit from a convertible note since, as we saw, you don't have to pay upfront. Everything is decided on the maturity date.  

It is good to highlight that opting for one of these notes cannot be a leap of faith; that is, when looking for investors, you must have at least perspective and a plan of approximately one year so that, in case of being approved, you can make the most of it. As we said before, certain investors do not believe much in this option given the uncertainty generated by the possibility of not receiving their investment in return, but we are sure that if you provide them with a well-structured plan, they could approve your project.

Ultimately, the best thing in these cases is to study all your financing options as a founder, and we offer you all the articles we are writing about startups.

If you want more advice with digital marketing, contact our team of specialists to receive the guidance that will lead you to success. Contact us now!

---