Traditionally, businesses had only two ways of raising funds – by selling shares or by taking out a loan. Depending on the type of business, the amount of money required and forecasted market conditions, the founders would take a call on the method of financing.
As an investor, you must be interested in backing startups based on the tremendous returns that the sector has generated. Even for startups, raising money is an essential function as they have negligible revenue. However, this isn’t an easy task since investors are taking on quite a bit of risk by betting on a business that might not even have a product or service offering yet. Startups today have a variety of funding options to choose from and particularly for seed-stage startups, the convertible note has become a preferred choice.
What is a Convertible Note?
A convertible note is a short-term debt that is extended to a startup by an investor with the promise of it being “converted” into equity in the company at some point in the future. The loan is extended at an agreed-upon rate of interest. However, the interest is not paid to the investor. Instead, the accrued interest plus the principal is converted into equity in a future financing round when a certain valuation threshold is breached. It is a hybrid between equity and debt.
Benefits of using a Convertible Note
The biggest benefit of a convertible note is that it allows for the valuation of the company to be put off to a later date. This gives the startup time to build and refine its offering, acquire customers and a reputation and generate financial statements. All the activities and the data they generate will significantly increase its valuation. That’s why this is the preferred method of external financing sought by founders.
Another advantage is that funds can be raised quite quickly, with minimal expenditure. In a normal fundraising round, investors demand multiple corporate documents, filings have to be made with the respective authorities and the fine points of the deal can get held up in negotiations for quite some time.
Investors have also begun to appreciate convertible notes as they receive certain benefits at a later fund-raising stage in return for betting on the company at an early juncture. They can purchase shares at a discount to the market valuation when the convertible note matures. In addition, the valuation of the company is capped at a predetermined amount for note conversion. Let’s look at the terms used in detail.
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Terms & Provisions of Convertible Note
While the issuing of convertible notes isn’t as complicated as a liquidity event, there are still some terms and conditions that need to be laid out in order to ensure a fruitful partnership. These terms are frequently used:
Any lender expects an interest payment on the principal and convertible notes are no different. However, the interest is not paid out. Instead, it accrues and is converted into equity, along with the principal, upon maturity. Interest rates are decided by discussion between the two parties and are generally in line with the market rates.
Conversion Discount Rate
As a reward for bearing additional risk by investing earlier, convertible note investors get shares at a discount to market value upon maturity of the note in a financing round. For example, if the shares are being sold to venture capitalists at $5 per share and the discount rate is 20%, then convertible note holders get shares at $4 per share.
Convertible notes have a maturity date at which the investors can demand repayment from the company if they have not already been converted to equity. The investor and the company can also choose to extend the investment based on new terms.
Another incentive that convertible noteholders receive in return for backing the company during a volatile stage is the valuation cap. The upper limit of the price at which the investment will be converted to equity is fixed, regardless of the valuation at the financing round. Investors seek a lower cap as it allows them to purchase a greater stake in the startup.
E.g: Let us assume a note is worth $10,000 at maturity and the valuation is capped at $100,000 even though the market valuation is $200,000. The investor will be able to get 10% of the startup instead of only 5%.
What is the difference between a safe note and a convertible note?
SAFE (Simple Agreement for Future Equity) notes were introduced by Y Combinator, a popular startup accelerator. They are simplified convertible notes. The key differences between a SAFE note and a convertible note are:-
- Interest rate: Convertible notes have an interest rate that can be decided upon by the involved parties. A SAFE note does not have an interest rate as it is not a debt.
- Maturity date: A convertible note’s maturity note can be finalised based on negotiations. A SAFE note must convert into preferred stock in the next liquidity event.
- Discount and valuation cap: A convertible note can have both and the conversion is done based on which method provides the investor with maximum returns. A SAFE note however has only either a discount cap or valuation cap.
Example of a convertible note
An investor purchases $10,000 worth of convertible notes that generate interest at the rate of 5% and provide a 20% discount rate. A year later, the startup raises funds at a valuation of $10 per share. The investment is now worth $10,500 and the stock’s price to the investor is $8 ($10 – 20% of $10). As a result, the conversion provides the investor with a little more than 1300 shares. If the investment had been made as a part of the financing round, the investor would have been able to purchase only 1000 shares.
What happens when convertible notes mature?
Usually, a convertible note never reaches its maturity date and is converted into equity in a liquidity event. However, if the company chooses not to go for further rounds of financing, then at the maturity date, the investor has two choices. The note can be extended by re-negotiating the terms and conditions. Or the investor can force a sale of assets to recoup the investment. Neither is an ideal scenario and this is why all possible outcomes need to be discussed and laid out in the documents, at the time of investment.
As an investor, there are multiple options available to invest in startups. It is important to understand the pros and cons of each method and assess your own risk appetite before making an investment. At Inflection Point Ventures, we help you by providing all the information you need to make an informed decision. You can reach out to us to learn more about how you can find the right startup to invest in.