Start –Up Funding: What Do we mean by Convertible Notes and Option Pool?

As a start-up company, you will definitely come across the term funding quite often, but convertible notes, that’s a new one. Being in the startup industry, it is required for one to be familiar with terms like these. So what does convertible notes really mean? Don’t worry, I am going to explain them to you in the simplest way possible.

But before that, let’s have a look at funding in a nutshell. Funding is the act of providing resources, usually in the form of money, time, efforts, or expertise to help support or promote a project or business. There are various sources of funding options. These includes:

a) Angel investors

b) Crowdfunding

c) Bootstrapping

d) From incubators and accelerators

e) Venture capitalists

f) Bank loans

g) Grants

h) Awards

i) Personal savings

j) Customers/revenue etc to name just a few….

On the other hand, convertible notes are short-term debts that a startup company has that is normally converted into equity. What happens, is that the notes issuer get to receive a certain number of shares at a discount as a form of reward for the additional risk involved in investing so early in your startup.

The number of shares to be formed is usually determined during the next rounds of funding or financing of the startup. While the convertible notes are often done during the first investment money that is taken by a startup. Therefore, it is vital to think keenly if your startup needs funding or bootstrapping before seeking, applying, and accepting any form of funding.

Now let’s look at some of the main challenges of having convertible notes:

1. The interest of the founders of the startup and the investors are often misalign.

2. The process may affect how the company will seek for future investments.

3. It may put off some of the future potential investors later on.

4. And finally, the process of issuing preferred shares tends to become almost as simple and convenient as possible.

A good example of the problem facing startups when it comes to valuation and funding after doing the convertible of notes is described below;

With a funding of let’s say $500,000, the company gets to be valued at $1.5 million pre-money valuation.

That being said, one should know that convertible of the notes to shares is not really a bad thing. There are advantages that comes with it. For instance;

1. It helps in delaying the valuation of the company.

2. It makes the variable pricing process possible.

3. The process of converting the notes into shares is fast, simple, and affordable.

However, one thing every startup should always remember is to create an option pool before seeking any investments. An option pool, as shown in the chart above, is simply a chunk of equity that is reserved for future hires. The pool is one of the ways that is used to attract potential investors, talent, and employees. Therefore, when planning to seek funds be sure to only seek the amount you need that will be used to hit a set milestone. A reasonable amount of funds to raise should be enough to operate the startup for the next 12–18 months.