Since convertible notes interest many people, we have decided to share one of our most read blogs about them on Medium as well:
Entrepreneurs are not always aware of the different financing tools available to them when raising funding, nor the implications of the different forms of funding for their company. Due to challenges with early-stage investing in shares the convertible note was invented. Convertible notes are a debt instrument with an interest rate. Though they have been the effective standard for seed-funding startups in the US for a long time, European startups have started to adopt that practice in the past couple of years. Leapfunder uses this method of raising funding due to its many benefits:
Advantages for early-stage investors
For an early-stage investor, the convertible note has different advantages. While a straight equity deal only delivers a profit if the shares go up, and delivers a loss if the shares go down. A convertible note can deliver a return to the investors in many different ways. First, there is the interest on the note, this can be accumulated and converted to shares so it does not have to be paid out in cash periodically. Second, a discount on the share price is offered when the convertible converts into shares. This means that when a note converts, the noteholders get an automatic reward for the risk they took in the form of a discount on the shares. Finally, there is often a cap, which represents an agreed maximum pre-money valuation at conversion. This makes sure that when a startup is extremely successful, the investor will benefit additionally from that success. This creates a win-win situation for both the startup and the investor: the investor has a high chance of a positive return, while the startup has a higher chance of securing the deal.
The valuation determines what percent of the company is being offered. However, this value can be quite difficult to determine for many early-stage ventures. One of the key advantages of issuing convertible notes is that the valuation issue is kicked down the road until the series A round of financing. In this round, there are a lot more data points and thus it’s much easier to value the startup. This makes the valuation more realistic. Since a convertible note is a loan (debt not equity), a value of the startup is not necessary, removing problems of dilution, taxes and option pricing. There is a higher chance of closing a successful financing round when there are no valuation negotiations.
Quicker and cheaper legal deals
When you are looking for different sources of investment, such as business angels or venture capitalists, it can be challenging to close a deal. Different parties have different demands and different preferred legal structures. A convertible note is an accepted standard and relatively easy to get agreement on. The contract is usually just between the startup and the investors: there is no notary involved, so everything is much quicker and cheaper. Convertibles are known to be agreed and closed within a week, while an equity deal can easily take several months.
An established form of seed investment
Convertible notes are financial products which have been at the heart of the startup scene for years. Usage of the convertible note is common worldwide in a variety of situations. In the US, notes are the effective standard for seed-funding startups. In Europe, they have been in use with VCs for years, and the general public is quickly learning about this financial tool. It is one of the default choices, next to shares, for startup financing and the web is full of sites that simply explain the note to new users. These sites are mostly aimed at the US, where note investing is the norm. The economics are the same in Europe, and investors here are quickly adopting the tool as well.
If you want to learn more about basic financial instruments click here.