One way early-stage startups raise funds without worrying about immediate equity dilution is through convertible notes. These notes are becoming more popular as they potentially balance the needs of both startups looking for early funding and investors.
In 2023, the issuance of convertible notes among US companies grew by 77% to $48 billion. While this growth was lower than in 2020 and 2021, it marked a strong comeback and was well above the decade average of $34 billion through 2019.
Startups are constantly seeking funding opportunities and more balanced terms for both themselves and their investors. However, to navigate the process of issuing convertible notes, you need a proper guide, and that's where this article comes in.
In this article, you’ll access the ultimate convertible note guide for startups, terms, and tips to help you make the most out of convertible notes.
Key takeaways
- Convertible notes are a type of loan that accrues interest. In the event of a future funding round or exit, they can be converted into equity in a startup.
- Convertible notes delay valuation, allowing startups to raise funds without immediately determining their valuation, especially for early-stage startups.
- Key terms include interest rate, maturity date, and valuation cap. Understanding these terms helps create a favorable convertible note agreement between a startup and an investor.
- There are alternatives to convertible notes like SAFEs (Simple Agreements for Future Equity), which are not debt instruments, unlike convertible notes.
What is a convertible note?
A convertible note, also known as a convertible promissory note or convertible debt, is a type of loan that you can later convert into equity in your startup. It offers you, as a founder, a flexible way to raise funds without the need to negotiate an initial valuation. Startups commonly use this financial tool to secure early-stage financing or as a bridge loan when your company needs funds the most.
How do convertible notes work for startups?
Selling a convertible note to an investor is like taking a loan from them instead of immediately selling equity. However, this loan can convert into equity, typically during a future financing round or an exit event.
Convertible notes include a principal amount, an interest rate, and a maturity date. Unlike traditional loans, investors usually prefer the loan to be converted into equity shares in your startup rather than receiving cash repayments.
For example, an investor might lend money to your startup via a convertible note, expecting repayment within two to five years. Before the note matures, they can choose to convert the debt into equity when you raise a larger funding round. If the note isn’t converted, you repay the full amount plus any accrued interest.
Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
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This type of funding compensates investors for their risk, leveraging a discount and a valuation cap. The note converts to equity at a predetermined discount or cap during events such as a priced equity round.
Convertible notes can be considered a pre-Series investment because they typically precede the first major funding round, like a Series A.
When and why startups choose convertible notes
Convertible notes are often preferred for their speed and simplicity, allowing you to raise funds quickly without the complex negotiations and the paperwork of traditional equity rounds. When you're still working to establish your company in terms of worth, convertible notes give you more time to build value.
This cost-effective option appeals to cash-strapped startups, while investors are drawn to incentives such as discounts and valuation caps. Convertible notes offer flexibility, catering to both your needs and those of your investors. Moreover, common conversion triggers include subsequent financing rounds, acquisitions, or IPOs.
Key terms in convertible notes
When dealing with convertible notes, you need to understand the key terms and their implications. Here’s a breakdown:
Interest rate
In convertible notes, the interest rate is the percentage you pay to the investor for the money they loaned you. Convertible notes, unlike traditional loans, typically carry a lower interest rate. The interest rate often ranges from 2% to 8% per year. This interest is usually added to the principal amount, which then converts to equity, boosting the investor’s returns.
Maturity date
The maturity date is the deadline for the convertible note. At this point, you either repay the principal plus any accrued interest or convert the note into equity shares.
Valuation cap
The valuation cap sets the maximum value for your company when converting a note into equity. It rewards early investors by allowing them to acquire equity at a favorable price, even if your company’s worth grows significantly before the next funding round.
For example, with a $5 million cap, if your next round values the company at $10 million, the investor’s shares convert as if the company were worth $5 million, giving them a substantial discount. To maintain fairness, align the valuation cap with realistic expectations for your next funding round to avoid over-rewarding early investors and diluting your ownership.
Conversion price and discount
The conversion price is the price per share at which convertible notes convert into equity. It’s typically determined by applying a discount to the price paid by new investors in the next equity round or using the valuation cap.
A discount, commonly 10% to 30%, gives your early investors more purchasing power by reducing the effective price per share they pay.
Future equity financing round
The future equity financing round refers to your next sale of equity to raise funds. This round sets the terms for converting convertible notes, including the conversion price.
Convertible notes vs SAFE (Simple Agreement for Future Equity)
A SAFE (Simple Agreement for Future Equity) was introduced by Y Combinator, a startup accelerator, in 2013 as an alternative to convertible notes. SAFEs is a financing instrument that allows investors to receive equity in a future funding round without a specific price per share at the time of investment.
SAFEs are not debt instruments; they do not accrue interest or carry a maturity date. Instead, they convert to equity when a triggering event, such as a priced equity round, occurs. The conversion terms are based on a valuation cap or discount rate, similar to convertible notes. Convertible notes, being debt instruments, come with an interest rate and a maturity date.
The choice between using convertible notes or SAFEs often depends on your startup’s industry. Convertible notes are more common in medical devices, hardware, and biotech sectors, while software-based industries favor SAFEs.
Unlike priced rounds, both options allow you to raise funds without immediately valuing your company.
Pros and cons of convertible notes vs SAFEs
Pros:
- You deal with a simpler structure compared to convertible notes.
- You avoid interest or maturity dates.
- You can execute SAFEs with minimal negotiation.
- SAFEs are often more startup-friendly.
Cons:
- SAFEs may be less familiar to most investors.
- Without a maturity date, you risk waiting indefinitely for conversion.
- Issuing multiple SAFEs with different terms can create unnecessary complexity.
- SAFEs may not comply with regulations in all jurisdictions.
- You might face unexpected dilution as the startup grows.
Convertible notes vs Revenue-based financing
Revenue-based financing (RBF) allows startups to access capital in exchange for a share of future revenue until a set amount is repaid without giving up equity.
This financing model preserves ownership, offers quick funding, and requires no valuation. However, it suits startups with consistent revenue streams and may temporarily strain cash flow.
Convertible notes vs Equity
With equity financing, investors get an equity share in the startup, and no debt is added to the company’s account. However, this process requires setting a valuation early and can be complex.
Convertible notes and equity both give investors ownership in a company, but they differ in how and when ownership is granted.
In convertible notes, equity is granted later upon an event like a funding round and may even be repaid in cash, but equity financing allows immediate dilution.
Example of convertible notes
A convertible note with a valuation cap and discount
Let’s say a startup issues a convertible note with:
- A valuation cap of $5 million
- A 20% discount
During the next funding round, the startup raises money at a valuation of $10 million, with new investors paying $10 per share.
Using the valuation cap:
- The noteholder's conversion price is based on the $5 million cap.
- Conversion price = $5 million ÷ total shares ($5/share)
The noteholder gets twice as many shares compared to new investors.
Using the discount rate:
- The noteholder receives a 20% discount on the $10 per share price.
- Conversion price = $10 × (1 - 0.2) = $8/share
In this case, the valuation cap provides a better deal for the noteholder, so they convert at $5/share. However, without a valuation cap, the noteholder cannot benefit from lower implied company valuation. Without a valuation cap, it is less risky for the founders but may be less appealing to early investors.
Convertible notes guide for startups
1. Due diligence: Before issuing convertible notes, you must conduct due diligence on the investors. This includes verifying their financial status, background, and previous funding.
2. Determine the terms: Define and decide on the key terms of the convertible note and any other relevant terms. Key features of convertible notes include conversion discount, valuation cap, interest rate, and maturity date.
3. Seek professional help: Consult legal and industry professionals to draft a comprehensive legal document. The document should also outline the rights and obligations of both your startup and the investor.
4. Execute: Once you finalize the agreement, ensure all necessary parties sign it. Keep records of the executed agreements.
5. Funding: The investor will transfer the agreed-upon funds to your company after signing the agreement. Ensure you document the transaction and use secure, traceable methods to receive the payment.
Afterward, keep accurate records, including accrued interest and conversion terms, using reliable accounting software.
6. Communication: You should also inform your investor of the company's progress. Share financial statements and significant events that could affect the conversion terms or their investment.
7. Conversion or repayment: Depending on the agreed-upon terms or the course of events, the convertible note will either convert into equity or be repaid to the investor with interest upon maturity.
Convertible note checklist for founders
Before signing a convertible note, founders should ensure:
- Review conditions and define key features such as interest, maturity date, triggers for conversion, and repayment terms.
- Understand investor and founder rights and protections. You can seek professional advice.
- Ensure regulatory compliance and verify adherence to laws and legal requirements in your jurisdiction.
- Ensure the note’s terms align with the company’s strategy, goals, and future funding plans.
Advantages and disadvantages of convertible notes for startups
Advantages of convertible notes
- You don’t need to determine your company’s valuation to secure funding.
- Investors can benefit from discounted shares or get their money back with interest.
- You can delay equity dilution, maintaining control during the early stages.
- Convertible notes are often easier to secure than equity funding.
Disadvantages of convertible notes
- Issuing multiple notes with different terms can create complex cap tables.
- Even if not immediate, there is potential for significant future dilution of ownership.
- Interest accrual adds to your debt, and some of the terms increase the equity you’ll need to issue upon conversion.
FAQs about convertible notes
How do convertible notes work for startups?
Convertible notes are debts that convert into equity at a discounted price or based on a valuation cap during a future financing round or specified event, while startups receive funds upfront.
What happens when a convertible note matures?
When a convertible note reaches its maturity date, there are two potential outcomes: conversion to equity or repayment plus any accrued interest. In some cases, there is an extension of terms.
Are convertible notes good for early-stage startups?
Convertible notes can be a good fit for early-stage startups, especially those needing quick funding with minimal legal and valuation hurdles. However, they may not suit every startup.
What happens if the notes don’t convert?
In the case of a maturity default, when your startup is unable to raise a round before the maturity date, the notes typically become payable plus any accrued interest. Businesses often extend the maturity date to avoid defaulting and to give them more time to secure priced funding.
Can convertible notes be converted before a future funding round?
Yes, sometimes it can be converted before the next funding round. This can happen in the case of an acquisition or sale of the startup, a mutual agreement, or a maturity date reached.
Do convertible notes have voting rights?
As it does not initially involve equity dilution, it doesn't give note holders voting rights until the notes convert into equity.
What happens to a convertible note if startup fails?
If a startup fails, convertible note holders are treated as creditors and are to be repaid. However, in most cases, noteholders may recover little or nothing as there are few or no assets left.
Can you cash out a convertible note?
Convertible notes usually convert to equity during a priced round or are repaid at maturity. In rare cases, an investor can sell their note to another investor if the terms allow and the company agrees.
Conclusion
Raising funds can be challenging, especially for early-stage startups that may struggle to meet certain requirements, such as determining their valuation. Convertible notes help by allowing delayed valuation while securing funding upfront. While this may eventually lead to equity dilution, it gives your startup time to grow and settle the note when you raise funds. Convertible notes can also be repaid when maturity is due and your startup is yet to raise funds.
As a founder, you benefit from the flexibility, while investors are incentivized through terms such as discounts and valuation caps. Make this ultimate convertible note guide for startups your companion to make the most of convertible notes.
Also, ensure you consult legal professionals to guarantee that the terms are clear, fair, and legally compliant. You must also understand all key terms, such as the interest rate, valuation cap, and maturity date. As an investor, remember that if the startup fails, you may recover little to nothing, so assess the risks carefully before investing.
