Everything you need to know about convertible notes

WOWS Global November 3, 2023

Convertible notes are becoming an increasingly popular financing option for startup companies. In this article, we will explore the ins and outs of convertible notes, including how they work, why startups use them, key terms and considerations, how to use them in a financing round, and common challenges and risks associated with convertible notes.

What is a convertible note?

A convertible note is a type of debt that can convert into equity at a later stage. It is often used by startups to raise capital in the early stages of their development when it may be difficult to determine an accurate valuation. Instead of pricing the company at that point, investors provide a loan to the company, which can later be converted into equity when a valuation is established.

How do convertible notes work for startups?

For startups, convertible notes offer several advantages. Firstly, they provide a quick and simple method of raising funds without the need for a full valuation or negotiation of share prices. Additionally, convertible notes often have a valuation cap and conversion price, which protect investors from disproportionately diluting their equity in the company if the valuation increases significantly before the conversion.

Example of a convertible note

Let's consider an example to better understand how convertible notes work. Suppose a startup raises $500,000 through a convertible note with a valuation cap of $5 million. When the company later raises its next financing round at a valuation of $10 million, the convertible note holders will have the option to convert their debt into equity at a discounted price based on the valuation cap, allowing them to purchase shares at a lower price and effectively increase their ownership in the company.

Why do startups use convertible notes?

Advantages of using convertible notes for fundraising

Startups often use convertible notes for fundraising due to their flexibility and simplicity. Convertible notes allow startups to secure financing without going through the lengthy process of determining a valuation and negotiating equity rounds. This can save both time and money, making the fundraising process more efficient.

Valuation cap and conversion price

One of the key advantages of convertible notes is the inclusion of a valuation cap and conversion price. The valuation cap sets a maximum price at which the convertible notes will convert into equity. This protects the investors from excessive dilution if the company's valuation increases significantly before the conversion. The conversion price is the actual price at which the convertible notes are converted into equity.

How do investors benefit from investing in convertible notes?

Investors can benefit from investing in convertible notes in several ways. Firstly, they have the opportunity to invest in promising startups at an early stage without the need to negotiate equity terms. This allows them to get a foot in the door and potentially unlock significant returns if the startup succeeds. Additionally, investors can benefit from the potential upside of investing in a company at a lower valuation through the conversion of the notes into equity.

Key terms and considerations with convertible notes

Understanding interest rates and maturity dates

When investing in convertible notes, it is important to consider the interest rate and maturity date. The interest rate is the rate at which the note accrues interest over its term. Typically, convertible notes have a lower interest rate compared to other types of debt due to the potential upside of converting into equity. The maturity date is the date on which the convertible note must be repaid if it has not been converted into equity.

Converting convertible notes into equity

The main purpose of convertible notes is to eventually convert them into equity. The conversion typically occurs during a subsequent financing round or upon the occurrence of certain trigger events. The conversion is based on a predetermined conversion price, which determines the number of shares the note holder will receive in exchange for their debt.

Managing convertible note holders and cap table

As a startup using convertible notes, it is important to manage the relationships with your note holders and keep an accurate record of your cap table. The cap table outlines the ownership structure of the company, including the shares held by founders, investors, and convertible note holders. Keeping a clear and up-to-date cap table is crucial for accurate decision-making and future funding rounds.

How to use convertible notes in a financing round

Structuring a convertible note financing round

When using convertible notes in a financing round, it is essential to structure the round correctly. This includes determining the terms of the note, such as the interest rate, maturity date, and conversion price. It is also important to create a clear and comprehensive term sheet that outlines the terms of the investment and any additional agreements between the company and the investors.

Negotiating terms in a convertible note agreement

When negotiating the terms of a convertible note agreement, it is crucial to consider the interests of both the company and the investors. Key terms to negotiate include the valuation cap, conversion price, interest rate, and any conversion discounts or other incentives for the investors. A well-negotiated agreement can protect the interests of both parties and pave the way for future success.

Key considerations for investors in a convertible note financing

As an investor considering a convertible note financing, it is important to carefully evaluate the terms of the agreement. Key considerations include the valuation cap, conversion price, interest rate, repayment obligations, and any potential impact on future funding rounds. Conducting thorough due diligence and seeking advice from legal and financial professionals can help mitigate risks and maximize potential returns.

Common challenges and risks with convertible notes

Repayment obligations and timing

One challenge of convertible notes is the need to repay the debt if it has not been converted into equity by the maturity date. Startups should carefully consider their ability to repay the note and ensure they have a plan in place to do so if necessary. Timing is also crucial, as repaying the note too early may result in missed opportunities for conversion, while delaying repayment can create financial strain and impact future fundraising efforts.

Impact on the startup's valuation and future funding rounds

Convertible notes have the potential to impact a startup's valuation and future funding rounds. The conversion of notes into equity can dilute existing shareholders, including founders and early investors. It is important to carefully monitor and manage the dilution to maintain a healthy balance between attracting new investors and preserving the value for existing stakeholders.

Understanding the discount rate and dilution for investors

Investors should carefully evaluate the discount rate offered in convertible notes. The discount rate determines the price at which the notes convert into equity relative to the price paid by new investors in a subsequent financing round. High discount rates can lead to larger dilution for early investors and potentially impact the overall return on investment. It is crucial to assess the potential dilution and weigh it against the potential upside when considering an investment in convertible notes.

In conclusion, convertible notes can be a valuable financing tool for startup companies. They offer flexibility, simplicity, and potential upside for both startups and investors. Understanding the key terms, considerations, and risks associated with convertible notes is essential for making informed decisions and maximizing the benefits of this financing option.

Q: What are convertible notes?

A: Convertible notes are a type of debt instrument that can be converted into equity in a future round of financing.

Q: How are convertible notes used?

A: Convertible notes are often used by early-stage companies to raise capital without having to determine the company's valuation at that time.

Q: What is a senior convertible note?

A: A senior convertible note is a type of debt that has priority over other convertible notes in the event of a liquidation or bankruptcy.

Q: What are the terms typically associated with convertible notes?

A: The terms of convertible notes can include the conversion price, interest rate, maturity date, and if applicable, conversion discounts or revenue caps.

Q: How do convertible notes convert to equity?

A: Convertible notes convert to equity when a qualifying round of financing occurs. The conversion is based on a pre-determined conversion price or a conversion formula.

Q: What is the investor's share price when a convertible note converts?

A: The investor receives equity at a discounted price or at a price based on the conversion formula stated in the convertible note terms.

Q: What is the difference between a convertible bond and a convertible note?

A: A convertible bond is typically a larger debt instrument issued by more established companies, while a convertible note is often used by early-stage companies to raise capital. However, both can be converted into equity.

Q: What happens if a convertible note is not converted?

A: If a convertible note is not converted, it continues to function as debt and the noteholders may receive interest payments until the maturity date of the note.

Q: Can convertible notes be converted before the maturity date?

A: Yes, convertible notes can be converted at any time before the maturity date if a qualifying round of financing occurs.

Q: How does a convertible note balance sheet look?

A: A convertible note is typically recorded as debt on a company's balance sheet until it is converted into equity.