What is a Convertible Note in Venture Capital?

by Adarsh Raj Bhatt in

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Key Takeaways

  • A convertible note is a short-term debt that converts into equity during a later funding round. 
  • A convertible note is generally a secure investment, especially in an early-stage start-up.
  • Businesses can force conversion of the debts into equity if the price of stock is higher than if the debt were to be redeemed.
  • Convertible notes will also help the investor earn interest. Interest is usually not paid in cash, but rather compounded, which ensures that the value owed to the investor grows over time.
  • Convertible notes are generally preferred by startups because they are quicker, simpler, and cheaper to issue than equity.
  • A valuation cap determines the maximum price at which the convertible security will convert into equity. 
  • The valuation cap might also be set at an initial stage, allowing investors to assess the success of start-up companies before investing large sums of capital.
  • Convertible notes are best for early-stage startups that have not been explicitly valued at a formal level yet.

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What is a Convertible Note in Venture Capital? 

A short-term debt that converts into equity is known as a convertible note. In the context of seed financing, the debt usually transforms into shares of preferred stock upon the completion of the Series A round of financing. 

In other words, investors lend money to a startup as its first round of funding, and instead of collecting interest, the investors receive preferred stock shares as part of the startup's initial preferred stock financing, as per the terms of the note. At a certain milestone, typically at the valuation of a later funding round, the remaining loan balance is automatically converted to equity. 

That’s not all ...

Convertible notes can contain additional provisions, such as caps and discounts, to compensate the angel investor for the additional cost of investing in the earlier round of startup financing.

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How do convertible notes work? 

Convertible notes are debt securities with terms such as maturity date, interest rate, and so on, but which can be converted into equity in the event of a potential equity round. The conversion is normally performed at a discount to the future round's price per share. 

A convertible note, as the name implies, is a form of short-term debt that transforms to equity when a conversion event occurs (usually when the startup raises a certain amount in its next fundraising round). Finally, the objective of a convertible note is to postpone valuing the startup until it has matured and proved itself, encouraging the startup to produce more data points and meet certain benchmarks that will enable investors to arrive at an acceptable valuation in the future.

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Benefits of convertible notes

1. Low-risk and high-yield

Technically, the terms of a convertible note do not sell real share ownership. For all intents and purposes, it remains a loan. As a result, both the issuer and the investor will escape the possibility of inaccurate company valuation, as well as tax consequences. 

This is ideal for startups, as determining valuation is challenging in the early stages. Founders should take note.

2. Pre-valuation investment

For most startups, the issuance of convertible notes is the first source of external financing. 

Since there is no need for a business valuation at this point, the startup will directly move on to the next round of funding. By this time, your startup will be likely to have established fair value through consistent efforts over a long period of time. 

At this stage, advanced metrics can be used to measure your startup's value.

3. Fixed income for noteholders

Because convertible notes are loans, investors who hold them are guaranteed a fixed income based on the concept of interest rates and valuation limits. Even though both of these would result in equity, having a guarantee on the amount invested is advantageous to investors. 

Furthermore, common shareholders who buy shares at a higher price per share earn more operating profits. The terms of convertible notes ensure profitable outcomes for both the issuer and the investor.

4. Voting power

Investors with convertible notes do not have voting rights on corporate matters, unlike common shareholders. 

Convertible notes come in handy if the management is worried about losing voting power during discussions about alternative funding options.

5. Simple documentation

Documentation for convertible note issuance is easier from a legal as well as an economic standpoint since the business valuation is parked for a later stage funding phase.

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Limitations of Convertible Notes

1. Absence of company control

A typical investor is a common shareholder who: 

  • Buys stock after a thorough analysis of the startup's performance 
  • Enjoys a measure of stability regarding their investment
  • Has voting rights in important business decisions

With convertible note terms, this is not the case. It can be challenging for new investors investing in a startup for the first time to determine if the terms of the note are fair. Aside from that, they would also have no say in most company affairs. 

2. Ambiguity

Since convertible note investments are often made in startups, one of the most common threats that investors face is repayment failure. The fledgling company will not be able to repay loans if it’s unable to raise additional equity funding. 

Also, automatic conversion provisions do not necessarily have to be included with all notes. Therefore, investors should clearly address the terms of the deal, including conversion clauses, and lay them out on a convertible note certificate to prevent any awkward situations or complications.

3. Danger of Bankruptcy

While a company valuation isn't needed for convertible note creation, the absence of one puts investors at a higher risk than ordinary shareholders (who can rely on hard evidence to justify their investment decisions). 

In addition to this, the shorter the maturity period, the higher the risk is.

Founders should be aware of such limitations that convertible notes have concerning investors.

4. Strict indenture provisions

Indenture requirements for convertible notes are usually much stricter than those for short-term credit arrangements or common or preferred stockholders. 

Thus, a long-term debt agreement can impose a slew of restrictive covenants on businesses.

5. Heavy debt 

Raising capital during a financial crisis is extremely difficult. In such circumstances, it is only natural for investors to provide financial assistance in the form of secured loans. 

Since convertible notes do not provide this guarantee, startups can find themselves in a difficult position, having to choose between attracting new bondholders and being accountable to existing ones.

What happens to the convertible note if a startup fails? 

If a startup raises capital on a note and then fails, the investors become creditors and receive their money before any shareholders or creditors who do not have security or statutory preference. 

Convertible noteholders in these cases are usually always fortunate to get pennies on the dollar. Personal guarantees on a convertible note would be very rare. 

What's more beneficial to a startup founder - convertible note or SAFE agreement? 

Both SAFE and convertible notes have the option of being exchanged for equity. 

The difference is that a convertible note can be converted into either the current round of stock or a potential funding case in the future, while a SAFE can only be converted into the next round of financing.

How to issue a convertible note for a startup? 

Convertible notes are normally only enabled when a "qualifying transaction" occurs (one that exceeds the minimum sum stipulated in the agreement) or when all parties consent to the conversion. 

On the other hand, when you collect some amount of equity investment, the SAFE will convert. This is appealing in terms of simplicity, but it denies the entrepreneur leverage, which is why the convertible note tends to be the best option for seed funding in this group. 

Another thing to bear in mind is that raising common stock does not trigger a conversion for a SAFE investor, so entrepreneurs in need of cash could do a "friends and family round" and skip the conversion trigger if they need to bridge.

A significant advantage of issuing convertible notes is that investors are not given any influence. When investors purchase preferred stock, they are usually given substantial control privileges, such as a board seat and veto power over certain corporate acts (such as the selling of the startup), under so-called "protective clauses." As minority stockholders, they also have some important privileges under existing state law (usually Delaware). 

In addition, if the startup raises funds from foreign investors through a convertible bond, it must comply with FEMA regulations within 30 days of receiving the funds. If the startup is unable to repay the debt by the maturity date, the lender can opt to extend the convertible note's maturity date up to the statutory limit of five years or request an actual repayment of the note. Much of this is dependent on the ability and success of startups.

Startup Convertible Note Template

Source

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