Convertible Note Basics for Startups

One of the most common trends in the startup scene is the issuance of convertible notes. For someone just getting started, it can be a difficult concept to understand. We wanted to make it as simple as possible. A convertible note is a financial intrustment that most early stage companies consider when they are looking for initial funding from friends, family or angel investors.

What’s a Convertible Note?

A convertible note is a debt that can convert into equity. Here’s how it works, instead of giving away 10% your company right off the bat to an early stage investor, the investor can issue a convertible note instead. This means that you’ll sign a contract that allows debt to convert into equity once you raise your next round of funding, typically a Series A. You also have the option of paying back the debt. The contract will typically contain an interest rate for the investment, a time period as to how long the note will last, a valuation cap and sometimes a discount.

Here’s an example, I want to invest 20k into company X. Instead of getting equity right off the bat for the 20k, my 20k + a negotiated interest rate will convert into equity upon the next round of funding or I can get paid back with interest. As the investor, I’ll also negotiate a valuation cap with the company.

What’s a Valuation Cap?

A valuation cap allows your initial investors to have their cash convert into equity at a lower valuation then subsequent investors. It’s essentially a cap on the valuation that your initial investors will have their cash convert into. For instance, if company X and an investor negotiated a valuation cap of 2 million dollars but during their series A or subsequent raise they end up raising money at a 5 million dollar valuation, the investors that gave you a convertible note would be able to convert at the lower valuation since that’s what they negotiated with you. In this scenario, the investors that gave you a convertible note are locked into lower valuation, which means more shares for them as opposed to the subsequent investors that don’t have a valuation cap. The idea is that a valuation cap rewards the early investors for taking a risk on your company, due to that risk they can end up with a better deal then subsequent investors and have more stock.

Advantages to a Convertible Note

Early stage companies and investors are very fond of convertible notes for a few reasons.

1) It takes the valuation out of the equation. You may think your company is worth 10 million dollars, however your first investor might think it’s only worth $500,000. By receiving a convertible note, you’re essentially putting off the conversation about your valuation until you raise your next round of funding. This allows you more time to focus on increasing your valuation and building your business.

2) The process is faster and cheaper. If you’re looking to move fast you can have a convertible note issued within a day or two and the legal fees are much lower compared to giving out equity.

3) You have more control by raising a convertible note. If you’re raising a convertible note, you’re not going to be giving away a board seat or significant discretion to the investor. This is important because it lets you operate freely. If you’re giving away equity, a venture capital firm or angel investor can ask for significant control, which they often do.

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If you need help raising your convertible note, then check us out at LawTrades.