Raising funds through convertible notes

Have you have heard about convertible notes? 

Convertible notes, or convertible bonds are a form of debt with interest paid on predefined terms and these notes can transform into equity when a clause, such as an equity financing event that was defined before or on the discretion of the investor, or any other condition that may be predefined in the contract.

When a convertible note converts into shares, the number of shares you receive is based on how much money you’re owed, including both the original amount you invested and any interest that has accumulated. This total amount is then divided by the conversion price, which is the price per share at the time of conversion. The conversion price could be lower than the current share price due to a discount or capped at a certain valuation, which allows you to receive more shares. In short, the more you’re owed and the lower the conversion price, the more shares you end up with when the note converts.

Characteristics of a convertible note

1. Principal Amount: The initial amount of money that the investor lends to the company. This principal is what will eventually convert into equity.
2. Interest Rate: Convertible notes often accrue interest over time. This interest is typically added to the principal amount and converts into equity along with the principal.
3. Maturity Date: The date by which the note must either convert into equity or be repaid. If the note hasn’t been converted by this date, various outcomes are possible, such as automatic conversion, repayment, or renegotiation.
4. Conversion Trigger: Events that cause the note to convert into equity, typically a future financing round where new investors buy equity in the company. Conversion can also be triggered by a sale or acquisition of the company, or sometimes at the discretion of the investor.
5. Conversion Price: The price per share at which the note converts into equity. This could be based on a discount to the price of shares in a future financing round, a valuation cap that sets a maximum company value for the conversion, or a predetermined price.
6. Discount Rate: A percentage that provides a discount on the price of shares in the next financing round. This gives the investor more shares for their money when the note converts.
7. Valuation Cap: A limit on the valuation at which the note will convert into equity. If the company’s valuation exceeds this cap during a financing round, the note converts as if the company’s value were at the cap, giving the investor more shares.
8. Automatic Conversion: Some notes automatically convert into equity upon reaching the maturity date if a qualifying financing round hasn’t occurred, typically at a pre-agreed price or valuation.
9. Repayment Terms: If the note doesn’t convert by the maturity date, the company may be required to repay the principal and any accrued interest.
10. Investor Rights: Convertible notes may include specific rights for investors, such as the ability to influence certain decisions or to be repaid before other investors if the company is liquidated.

How can a convertible note benefit startups?

Convertible notes offer significant benefits for startups, particularly in the early stages of growth. One of the key advantages is that they allow startups to raise capital without having to determine the company’s valuation upfront. This is especially valuable when the company is too young or its market potential is uncertain. By deferring the valuation to a later stage, startups can secure funding quickly and focus on building their business. Additionally, convertible notes are generally quicker and simpler to negotiate compared to equity financing, which reduces legal costs and speeds up the fundraising process. 

Another benefit is the flexibility in terms, such as the maturity date, interest rate, and discount rate, allowing startups to tailor the agreement to their specific needs and attract a broader range of investors. Convertible notes also help reduce immediate dilution of ownership, enabling founders to retain more control until the note converts in a later financing round. By offering a mix of debt protection and potential equity upside, convertible notes are appealing to investors, making it easier for startups to secure early-stage funding. This streamlined approach allows founders to concentrate on growth, reaching important milestones before transitioning to more complex equity negotiations.

Navigating the complexities of convertible notes can be challenging, especially for first-time fundraisers. But don’t worry—The Venture Builder is here to guide you every step of the way. Our team is ready to provide you with all the information and support you need to make informed decisions.

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