As a seed-stage startup, you probably don’t have a high amount of traction or not even a product yet, but one thing you will certainly need: investors. And you know, what investors need?! Key figures, exact numbers, and clear outcomes to calculate the value of the startup and get stakes accordingly. But in the early stages, providing that is not the easiest thing, since you probably don’t have more than a top-notch idea, some core elements, and motivation through the roof! But believe us, the long valuation process, which can take up to 6 months, will decrease your motivation… How to mitigate and proceed with the investment without waiting for the valuation? Convertible notes. Scroll for more.
What’s a convertible note?
Convertible notes or convertible loans are financial instruments offered to the investor, which define the conversion of the investment into equity at a future valuation. The aim is to put the funding itself in the center of attention and to push the long valuation procedure (legal processes for example) back to second priority.
If the founders and the investor cannot agree on the precise worth of the company, they can use a convertible note to delay the exact result of the valuation, while still proceeding with the investment itself. The money invested in the present will be represented in the form of a note – instead of issuing new shares.
The conversion of the investors’ stock (issuing new shares for the investor) will occur in the future, where the worth of the company can be evaluated more precisely. The main advantages are that investors can still contribute to the company’s growth and that this is a fast method of raising capital. Funding by convertible notes is also called “Bridge Funding”.
How a convertible note works
A startup in its seed stage has a solid foundation of the company and decides to go for the first priced round to raise capital.
- There’s a potential investor, but the founders and the investor cannot agree on the precise worth of the company, since the seed-stage nature of the startup doesn’t allow to have enough market information available.
- To mitigate that, they can use a convertible note to delay the exact result of the valuation (pre-money or post-money), while still proceeding with the investment itself.
- The money invested in the present will be represented in the form of a note (instead of issuing new shares now), and the conversion of the investor’s stock (= issuing new shares for the investor) will occur just in the future, where the worth of the company can be evaluated more precisely.
The invested money – represented by a convertible note – will give guidance about the worth of the startup for future investors, who are involved in the next round of raising capital, called the Series A round. The investors of the Series A round offer investments, defined by their own valuation of the company (based on the seed stage investor’s worth of convertible note). This future valuation, extended with the series A investment creates a more precise worth for the startup.
Why convertible notes?
The main advantage is that a convertible loan is a fast tool for raising capital. Since the method postpones the valuation process, investors can more quickly contribute to the startup’s growth, while eliminating long negotiations and related legal costs. Is it advantageous for the investor? Ideally yes, because next to receiving interest (usually around 5%) for their investments, they also get a discount, since convertible loans are considered risky.
What is a convertible note discount?
Next to an interest, a discount is also offered to the investor to compensate for the early trust. The discount is a percentage deduction from the future valuation of the future investor, by which the note will convert into shares. This percentage is generally 20% but can go as high as 35%.
What is a convertible note cap?
The cap is the maximum (future) valuation at which the convertible note will be converted into equity. It’s set right when the early investment is made and doesn’t have its own maturity date.
How do convertible note caps work?
Let’s take our example from above.
- The early investor decides to invest as a convertible note 200.000$, with a 5.000.000$ cap.
- If our future investor would value the company at 15.000.000$, the note will still convert at the 5.000.000$ valuation instead of the 15.000.000$ valuation.
- The cap protected the early investor to receive instead of 1,3% equity (200.000/15.000.000), 4% equity (200.000/5.000.000). This mechanism rewards the initial investor for their early trust and is present also when the company gets acquired.
When does a convertible note convert?
The lucky scenario is that the startup is growing as projected, the next funding round, Series A is successful and the note will convert into shares at a discount, based on the Series A round valuation. In this case, the cap is not exercised.
The less lucky scenario is when the startup doesn’t grow as fast as projected, and there is no funding round thus the investor would convert its note at the maturity date at the cap. This is not preferable for either of the parties: because of no additional funding rounds, the startup is likely to lack the resources to pay for the note (either as shares or as a pay-back) and the investor wasn’t in the startup for his interest. In the worst-case scenario, the startup has to file for bankruptcy, but generally, the parties agree to a maturity date extension for some more years or to start a repayment schedule, where the startup pays in installments.
If you want to raise capital relatively fast and don’t want to wait for all the valuation paperwork to be done, a convertible note is your way to go. But don’t start dreaming about having transferred the money from the investor by tomorrow just yet! First, get a deep overview of how convertible notes exactly work, and what the components are like interest rate, discount, or cap.
If you have any questions or you simply want to express your opinion, feel free to leave a comment below!
(This article by no means replaces official legal consultancy. It serves as a guide – for concrete legal advice please reach out to a lawyer.)