TL;DR
A convertible note is a type of short-term debt that converts into equity, typically in the form of preferred stock, during a future financing round.
Convertible notes are often used in early-stage fundraising because they delay the need to determine the company’s valuation. This is particularly useful for startups that are still in the process of proving their concept or scaling their operations.
How Do Convertible Notes Work?
The mechanics of convertible notes can be broken down into several key components:
1. Principal and Interest
When an investor provides funding through a convertible note, it is recorded as debt on the startup’s balance sheet.
Like any other debt, it has a principal amount and typically accrues interest over time. However, the intention is not for the startup to repay this debt with cash but to convert it into equity.
2. Conversion Trigger
The conversion of the debt into equity usually happens during a future financing round, such as a Series A.
The convertible note automatically converts into shares of the company’s stock based on the terms outlined in the note agreement.
3. Conversion Discount
Investors in convertible notes often receive a discount on the price per share when the note converts into equity.
This discount compensates the investor for the risk they took by investing early. For example, if the conversion discount is 20%, and the next round’s share price is $1, the investor would be able to purchase shares at $0.80 per share.
4. Valuation Cap
A valuation cap is another common feature of convertible notes. It sets a maximum valuation at which the note will convert into equity, protecting the investor from excessive dilution in the event that the startup’s valuation skyrockets before the conversion.
For example, if the valuation cap is $5 million, and the company’s valuation at the time of conversion is $10 million, the note will convert as if the valuation were $5 million, giving the investor more shares.
Benefits of Convertible Notes
Convertible notes offer several advantages, especially for early-stage startups:
- Deferred Valuation: Startups can delay the need to establish a company valuation, which is often challenging in the early stages. This allows them to raise funds quickly without getting bogged down in complex negotiations.
- Speed and Simplicity: Convertible notes are typically simpler and faster to execute compared to equity financing. The legal and administrative processes are less complex, which means startups can access funding more quickly.
- Investor Incentives: The combination of a conversion discount and a valuation cap provides early investors with the potential for significant upside if the startup performs well, incentivising them to take on early-stage risk.
- Flexibility: Convertible notes offer flexibility in structuring the terms of investment, allowing startups to tailor the deal to their specific needs and the preferences of investors.
Example of a Convertible Note in Action
Let’s consider a fictional startup, GreenTech Innovations, which issues a $100,000 convertible note with the following terms:
- Interest Rate: 5% per annum
- Conversion Discount: 20%
- Valuation Cap: $3 million
Scenario: Series A Funding Round
One year later, GreenTech Innovations raises a Series A round at a $5 million valuation. The investor’s note, including accrued interest, converts into equity as follows:
- Accrued Interest: The $100,000 note accrues $5,000 in interest, bringing the total amount to $105,000.
- Conversion Price: The investor gets a 20% discount on the $5 million valuation, meaning their note converts at a $4 million valuation ($5 million x 80%).
- Shares Received: The investor’s $105,000 converts into equity at the $4 million valuation cap, giving them more shares than they would have received at the actual $5 million valuation.
Conclusion
Convertible notes are a versatile and powerful tool for startups looking to raise early-stage funding without the complexities of immediate valuation.
Interested in learning more VC related terms? Head over to our VC glossary!