A Convertible Note is a type of debt instrument commonly used by early-stage startups to raise capital.
It is essentially a loan that can be converted into equity (ownership in the company) at a later stage.
Here’s how it works in simple terms:
- Loan: The investor gives money to the company as a loan.
- Interest: Like any loan, this loan may have interest, meaning the company will owe a little more than it borrowed overtime.
- Conversion to Equity: Instead of repaying the loan in cash, the investor have the option to convert the loan into shares of the company’s stock. This usually happens at a later funding round when the company raises more money from investors.
- Discount and Cap: To make the deal attractive, the convertible note often comes with a discount or a valuation cap.
- Discount: The investor gets to buy shares at a lower price than new investors.
- Valuation Cap: This sets the maximum price at which the loan can convert into equity, ensuring the investor gets a good deal if the company’s value increases significantly.
Example
Let’s say:
Mr Mark invest $2M in Mr John’s company, Mark gets issued a convertible note with a 5% interest rate per annum which is to convert on a maturity date of two (2) years.
At the maturity date, Mr Mark can either decide to get his initial invested capital plus accumulated interest, or a certain percentage of shares in the company.
Why Convertible Note instead of direct Equity
It’s advisable for early stage startups who are unsure of their accurate valuation to opt for Convertible Note instead of Equity. Convertible Note allows investors to wait until a large proper equity round with an agreed upon valuation takes place.
If the startup is yet to raise a seed round upon maturity of the loan (convertible note), the investor and the startup can agree to delay the valuation & terms of the investment until a “qualified financing” takes place.
Why do investors love convertible notes?
- It gives them a chance to get a “discount” on the investment terms whenever a qualified financing takes place
- They also enjoy the perks of the “interest”.
A convertible note is undoubtedly a valuable resource for startups. It has the potential to provide needed funding for startup companies during the early stages of their development without burdening them with onerous terms.
