What is a Convertible Note + How to Use Them Wisely for Startup Funding

The world of startup funding is complex, multifaceted, and overwhelming for many founders. Your fantastic idea needs financial backing to get off the ground, but there are so many funding options and ways to structure deals it’s hard to know what is best for your fledgling company. In this short yet informative guide, Abrams Valuation Group, Inc. experts break down convertible notes as a startup funding tool and offer guidance on how to use them wisely.

What is a Convertible Note?

A convertible note is a debt instrument that allows startups to raise capital without immediately giving up equity to investors. It works like a loan that can later be converted into equity, usually during a subsequent equity financing round or an exit event. The note accrues interest like a loan, and when the note reaches the maturity date, it either converts into equity for the investor or the startup needs to repay the loan plus interest. Very early stage companies often rely on convertible notes to secure some or all pre-seed funding quickly with minimal red tape.

A convertible note allows investors to support startups in the earliest stages with the potential for equity ownership once the company is more established and has a clearer valuation.

Benefits of Using Convertible Promissory Notes

There are several advantages to using convertible notes for both founders and investors. Let’s examine a few of the main ones.

Convertible Note Pros for Founders

• No need for a valuation One of the biggest advantages for startup founders is that they don’t need a company valuation to issue convertible notes. These debt instruments, also called convertible promissory notes or convertible debt, allow startups to secure funds flexibly while postposing a precise equity valuation to a later stage. Unlike other types of equity funding, which rely on a company valuation to determine a fair ratio of funding to equity, convertible notes delay the need for a valuation by promising note holders the option of future equity at a later stage in the company’s growth. This delayed valuation is beneficial for early-stage startups for whom there might not be enough data yet to determine an accurate company valuation.

• Expedited funding process Promissory notes allow founders to secure funding quickly, as it eliminates the hours of negotiation over exact equity stakes that are common in later equity funding stages. It’s a quick way to raise early capital for a startup, which can be vital to getting operations off the ground at the outset.
• Flexibility The nature of convertible debt is that is provides flexibility. Founders can raise capital quickly without committing a specific amount of company equity upfront. This allows them the time and the funding to grow their company to a more stable place where it will likely be able to command a higher valuation and attract more investors in their next equity financing round. Promissory notes give founders the flexibility to execute that growth without having to make too many difficult decisions at the start.
• Delayed Equity Dilution Because a convertible note does not issue equity to the investor immediately, it pushes off the founder’s equity dilution until the note is converted into equity. This is a huge benefit for founders, as it allows them to maintain greater control over the key company decisions at the early stages of the company, without other investors’ influence.

Convertible Note Benefits for Investors

• Potential for High ROI Convertible notes often come with several benefits that reward early investors for taking on what some would view as a risky investment. Convertible notes generally offer valuation caps and conversion discounts, both of which increase the potential ROI for the investor if the company performs well. These perks put the note investors at a greater advantage than typical equity investors, as they can end up getting more shares for a lower initial investment.
• Investor Protection through Interest Accrual A convertible note offers investment security for investors willing to take the risk on an early stage startup. Since the note will either convert into equity if the company does well or need to be paid up as a loan plus interest by the maturity date, investors can be confident that they will see a return on investment, whether in the form of company equity or accrued interest.
• Simplicity & Speed The process of investing through convertible notes is typically more straightforward and quicker than other investment vehicles. These notes often involve less legal complexity and can be issued with simpler documentation, streamlining the investment process.

Key Terms in a Convertible Note Agreement

Now we’ll examine the components of a typical convertible note agreement structure. We’ll define each term and discuss the relevant value implications it has for both parties.

Valuation Cap

A valuation cap is the maximum valuation used to determine the equity conversion price for a convertible note. This cap protects early investors by ensuring they receive a favorable conversion rate for their investment, as it limits the valuation at which the note will be converted into shares. The lower the valuation cap, the more shares an investor will receive.

Maturity Date

The maturity date is the time when the convertible note debt comes due. On this date, the note will either be converted to equity shares, or the startup will have to repay the principal plus any accrued interest to the investor.

Interest Rate

The interest rate is the percentage the investor charges the startup for borrowing money, just like a regular loan. The interest rates on convertible notes are usually low, around 5-8% per year. If the note is not converted into equity by the maturity date, the startup will have to repay the investor the investment principal plus accrued interest, like a traditional loan.

Conversion Discount

The conversion discount is the discounted price at which convertible note holders can convert their notes to equity shares. This gives the note investor an advantage over later equity investors in which they can acquire more equity at a discounted rate. Not all convertible note have both a valuation cap and a conversion discount, but that will depend on the note terms negotiated between the startup founders and investors. The bigger the discount, the more advantageous it is for investors.

Convertible Note Example

Let’s use an example of early stage Startup, Inc. to illustrate how convertible notes work:

Convertible Note Terms

Principal Amount: $500,000

Interest Rate: 5% per annum

Maturity Date: 2 years from issuance

Valuation Cap: $5 million

Conversion Discount Rate: 20% (optional, in case a valuation cap isn’t in effect)

Startup, Inc. issues a convertible note to an investor in exchange for $500,000 investment funds. One year later, Startup, Inc. successfully raises a Series A funding round at $10 million pre-money valuation.

Conversion Calculation

Price per Share at Valuation Cap

Since the note’s valuation cap is $5 million, the note holders must convert their notes into equity at this point either based on the valuation cap or the discounted conversion rate, whichever works out more to the investor’s benefit.

Startup, Inc. is valued at $10 million (pre-money) and issues 1 million shares at $10 per share (without the valuation cap).

At the valuation cap of $5 million, the equivalent price per share formula is

Price per share at cap= Valuation cap/total shares at cap

so $5 million/1 million= $5 per share.

The investor can convert their convertible note to equity at the highly discounted rate of $5 per share, which is 50% of the uncapped $10 price per share. In this case, using the valuation cap is more advantageous to the investor than using the conversion discount rate of 20%.

However, if there were no valuation cap in place in the convertible note terms, the investor could use the 20% conversion discount rate to convert their note at $8 a share, rather than $10 per share.

Factoring in Interest

The convertible note accrued 5% interest over the last year. That interest also has to be converted.

5% x $500,000 = $25,000 interest. So the total value of the note being converted is the principal + the interest $500,000 + $25,000 = $525,000

Number of Shares Issued upon Conversion

Shares converted = total amount converted/price per share at valuation cap

So $525,000/$5 per share = 105,000 shares

Upon converting the note to equity, the investor received 105,000 shares of Startup, Inc. for their initial investment of $500,000 in the company.

Cons of Using Convertible Notes for Startups

Although convertible notes offer significant advantages to both startups and investors, there are several drawbacks to using convertible notes for startups. It’s essential to be informed of both sides of the coin to facilitate making a smart decision for your company.

Considerations for Startups

• Failure to Secure Future Financing: If a startup doesn’t grow as expected and fails to attract enough new investors to complete subsequent rounds of funding before the maturity date, founders may be left with weighty convertible debt that can bankrupt their company.
• Severe Equity Dilution: Founders who issue too many convertible notes without carefully thinking through the valuation implications or terms may end up giving away far too many shares of equity early in the company’s lifespan and severely diluting their own ownership stake in the company. In drastic cases, this can even lead to the founders being pushed out of a company they no longer own, having given away too much equity to have a meaningful say in company decisions.
• Legal Complications from Poorly Planned Notes: Although convertible notes are easier to structure than other types of equity deals and can save startups legal fees upfront, this can backfire if not planned and executed properly. Adverse ramifications of poorly planned convertible notes can require hours of professional legal assistance to untangle, usually to the startup company’s detriment and expense.

It’s important for startups to carefully weigh their funding options with relevant advisors to ensure they’re making intentional, informed decisions for their company.

Alternatives to Convertible Notes

There are several funding alternatives to traditional convertible notes that provide more protection for founders. Some alternatives include SAFE notes (Simple Agreement for Future Equity) and KISS notes (Keep It Simple Security), which offer more protections for investors and are considered more investor-friendly.

Unlike convertible notes, which are a hybrid of debt and equity for the startup company, SAFE, and KISS notes are purely equity instruments that do not have interest rates or maturity dates. These notes are structured more as agreements to allow investors to convert their investment into equity at a future date. They lack the same investment security for investors as convertible notes since they are not loans that have to be repaid in the event that the company fails. However, they still offer investors advantageous terms to acquire preferred stock while giving more protection to founders.

How to Use Convertible Notes Wisely: Best Practices for Startups

1. Understand the pros and cons of using convertible notes as a funding mechanism for both founders and investors.

2. Have a clear plan for all eventualities, including the possibility of not securing future financing. What is your worst-case scenario plan of action to repay investors if the company doesn’t grow as expected?

3. Don’t rely on convertible notes too much. Issuing too many convertible notes, especially at an early stage of the company can backfire terrifically on an overeager founder, saddling them with enormous amounts of debt that can lead to bankruptcy or else leaving them with a minuscule percent of ownership in their own startup company.

4. Work with a lawyer who is knowledgeable in fundraising for startups and can structure convertible note terms to be both legally compliant and protect founders as well as investors.

5. Consult with a valuation expert before issuing convertible notes or any other form of current or future equity in your company. Having a clear understanding of the affect of different decisions on your company’s value is crucial to avoid giving away too much equity unnecessarily and avoiding excessive founder equity dilution.

Conclusion

Convertible notes can serve as a valuable financial tool for both startup companies and investors when approached thoughtfully. It’s crucial for both parties to have a comprehensive understanding of the all potential scenarios and the impact those outcomes can have on the company value and the investor’s money. Companies should carefully weigh convertible notes against other available funding options to determine the best option for their capital needs. If you’re considering convertible notes or any other funding strategies for your startup, we encourage you to reach out to Abrams Valuation Group, Inc. for a free consultation. Our team can help you strategically plan your funding to set your company up for success.

FAQs About Convertible Notes