What is a Convertible Note: Every Startup should know

The era of successful seed funding is currently underway. India has recently become the third largest startup ecosystem, and everyone from venture capitalists to the friends and families of startup owners are looking for the next Zuckerberg. Investors are actively participating in startup funding and investing in early-stage startups. The issuance of convertible notes for seed financing has never been more widespread.

This article discusses convertible notes and their benefits for startup founders. Before diving further into this topic, let us first discuss the convertible note definition and look at some examples. 

What Is a Convertible Note?

A short-term loan instrument that converts to equity is called a convertible note. Upon the completion of a Series A round of financing, the convertible debt in seed financing often transforms automatically into company shares. 

Convertible notes in startups are an instrument that acknowledges the receipt of money initially received as a debt. Convertible notes in startups later get converted into the company’s equity or are repayable at the option of the holder. It must be noted that these instruments are converted into equity within a period not exceeding five years from the date of their issue of the convertible note.

Particularly in seed-stage organizations, convertible notes have grown in popularity. Therefore it is crucial to comprehend the potential advantages and drawbacks of this type of financing and to determine whether it’s the best solution for your company.

In the end, this gives the startup investors the financial exposure of an equity investment while expediting the initial investment process and lowering the company’s legal costs.

What Happens To Company Shares Given To Investors?

Company shares are also given to startup investors. Many incubators allow for the disbursal of common shares owned by the company at the early investment stage.

Mostly the common stock is issued only to friends and family. However, most knowledgeable investors will insist on purchasing preferred stock instead of common stock because it has additional rights.

What must be included In Convertible Notes:

Given below are some of the key elements that are included while organising a convertible note:

Interest:

The funds are invested in convertible notes in order to earn interest at a level equivalent to other convertible debt investments while the conversion note is in effect. Since interest is frequently compounded rather than paid out in cash, the amount owed to the investor increases over time.

Maturity Date:

Convertible notes have a maturity date, after which the company needs to repay the due and unpaid amount if the notes haven’t already been converted to stock. 

Conversion Provisions:

A convertible note’s primary goal is to convert into equity eventually. In most cases, when an equity investment surpasses a predetermined threshold, then the conversion occurs. This is also called qualified financing.

Specific convertible notes additionally have a condition that the absence of qualified financing allows them to automatically convert to stock at a predetermined value on the maturity date.

Conversion Discounts:

The holders of convertible notes not only receive credit for their initial amount and interest charges but also typically receive a discount on the price per share of the startup capital.

Valuation Cap:   

Convertible notes commonly include a valuation cap, which sets a hard cap on the price determined for noteholders regardless of the price per share in the subsequent round of equity funding, in addition to the conversion discount. 

A valuation cap is an additional advantage offered to investors who choose to invest in startups during an early phase. 

Let us now look at a Convertible Note Example:

The investor buys convertible notes with a $25,000 purchase price, an 8% interest rate, and a 20% conversion discount. The company sells stock at $3.50 per share in a startup capital, which happens 18 months after the convertible notes are sold.

The sum due to the note investor will be $28,000 after the interest of $3,000 has been added to the notes. The investor will get 10,000 shares of the new stock for the conversion price of the notes, which is $2.80 after the 20% reduction. The above convertible note example clearly shows that there is unquestionably a significant benefit for the convertible note investor for the risk they take because if they had delayed buying the stock until the time of the startup funding, they would have earned 7,143 shares of stock.

Advantages Of a Convertible Note:

Let us learn more about the advantages of using a convertible note for startup capital.

• The corporation can postpone valuing itself by issuing a convertible note rather than shares. It is alluring for seed-stage businesses that haven’t had much opportunity to gain significant traction with their product and sales. As a result, many startup investors employ convertible notes as their first outside investment when making accelerated investments.
• Not granting any power to investors is a crucial benefit of issuing convertible notes. According to the so-called “acceptable level of risk,” investors who purchase preferred stock often acquire some necessary control rights, such as a shareholder vote and the ability to veto certain corporate decisions (including the sale of the company).
• Rapidity, accessibility, and affordability! A business might complete a convertible note round in a day or two by releasing a 1–2-page loan agreement with legal fees of just $1,500-$2,000.
• Businesses are increasingly using convertible notes in seed investments since they accelerate the closing of transactions. They assist entrepreneurs in breaking the type of impasse that develops when investors all wait to see who else is going to invest by making it simple for firms to offer different rates to different investors.

Disadvantages Of Using A Convertible Note

Now that you have seen the pros of using a convertible note let’s discuss the cons or disadvantages of carrying a convertible note.

• Even though the note holders gain equity rights, they sacrifice certain rights given to traditional shareholders. Some such rights include voting rights, control rights, pro-rata rights, and a say in the company’s liquidation. This reason can deter potential investors from taking convertible notes in business startups. They may rather prefer an equity stake.
• Until the conversion occurs, the convertible note holders have minimal control over their investments compared to equity holders. Also, the fact that future investors would determine the value of their investments and they would not be a part of this arrangement may act as a deterrent for most investors.
• Regarding shares of company stock, the countdown begins ticking as soon as a share is issued, whereas noteholders must wait until the conversion date to start making long-term capital gains. 

Conclusion:

Most high-growth business startups depend on outside investment, from angel investors, traditional venture capitalists, high-net-worth investors, or even close friends and family for investments.

Not all startup investors will find convertible notes an easy option. It’s always advisable to research thoroughly whether convertible notes would suit your company or whether you would instead prefer the traditional route of raising capital for your business.