You are a new startup and you need to raise some capital. You have a great idea but no money. A convertible note seems like the way to go, but you are not sure how it works, or if and when you will need to pay it back.
A convertible note is a short-term debt that will convert to equity. A convertible note is used in the early stages of a startup to raise money against the potential value of a company. It delays the time the loan will need to be paid back. When the convertible note comes due, the note will either be:
- paid off with interest
- extended with another round of fund-raising
- converted to equity
When you start a company, you need some money to get off and running. Unless you are independently wealthy and already have the cash, you need some sort of outside source to help finance your venture. You also need the time to build your company and make a profit for both you and your investors. In this article, we will discuss if a convertible note is debt or equity, how convertible notes work, and their pros and cons.
What is a Convertible Note?
A convertible note is a way to raise funding for your startup venture almost before you have a company to start. A convertible note allows you to get the money you need, but not have to worry about paying it back right away. A convertible note very simply put is a short-term loan that will eventually convert to equity based on the eventual success and profitability of a company.
Say you wanted to open a brick and mortar store. You would need cash for the building and the inventory to start. To raise the money, you could borrow against the equity in those physical items. If you don’t pay the financed amount back by the end of the terms agreed to in the loan with interest, the investors can take your business, sell off the equity, and demand payment, in order to get their money back. Yes, it is much more complicated than that, but stay with me.
Now, if you want to startup a technology venture, you don’t have anything physical to use as equity. All you have is your concept and a general idea of the potential success as well as the profit margin your startup will eventually generate. Think Etsy and Twitter.
The company barely exists at this beginning fund-raising stage. That’s when a convertible note comes in handy. A convertible note lets the startup use seed money to build their business with a promise to pay it back when the gamble pays off. The beauty of a convertible note is that you don’t need to know all the details about how the company will achieve its goals. You just need some way to convince investors that they will make money when they invest in your company.
That is the very high-level definition of a convertible note. Of course, it is much more complicated than that. Let’s take a look at what is involved in a convertible note and how it works.
Are Convertible Notes Long-term Debt
Convertible notes are a hybrid investment. They stay as debt until they are converted. When they are converted, they reflect on the balance sheet as equity. Until that point where the note is exercised, it continues to show as debt and continues to accumulate interest.
What is Equity
Equity represents the value of a company after all its debts are paid and its assets liquidated.
Equity = Assets – Liabilities
The price of the stock incorporates the cost of the equity. For accounting purposes, equity is defined in financial statements as the book value of the company.
Stocks are the representation of the company’s value on a publicly traded market. Stocks incorporate the company’s equity into their price. When an investor is buying stock in a company, they generally expect to make money through dividends and trades when the stock price increases as the company grows.
How a Convertible Note Works
In the U.S. issuing new stock is a long difficult process. For a startup company that has essentially only the promise of potential profit, issuing and then selling the stock to raise capital is:
- Too time-consuming
- Too expensive
- Not practical
A convertible note allows the business to raise money quickly and figure out the details later.
When an investor is considering putting their money into a company, they want to make their money back and then some. In order to pay its investors, a business can either pay back the loan with interest (debt) or issue stock in the company (equity). The better choice for the entrepreneur and the investor is to have the convertible note convert to equity so that the company can use that money to continue to grow and develop.
Parts of a convertible note:
- Maturity date
- Interest rate
- Conversion Cap
Each of these pieces of the convertible note affects how the initial backers will be rewarded for their early investments.
What is the Maturity Date on a Convertible Note?
In a convertible note, an investor is financing the potential of a company. An investor wants the company to succeed and do well so that their one-time investment continues to grow and earn money. When the first equity round is established, the founding investors agree that within an established time-frame (maturity date) the loan will either be paid back with interest or it will convert to equity in the company.
If all is going well and the company is making a profit when the note matures, the founding investors are paid interest on their outlay. The investor is then issued stock to fulfill the original loan amount, plus additional stock in the amount of the interest. On top of that, they get the converted equity at a discount. All this should meet the original expectations set in the first equity round.
As the maturity date looms closer, talks should begin about extending the length of the note. This will also involve another equity round where the business owner pitches their company to a new group of investors to raise more capital in order to continue growing their company.
If the startup is not doing as well as expected, the founding investors can call in their debt. The company is then obligated to pay back the loan and interest under the terms of the convertible note agreement. At this point, the two parties can agree to how that will happen. The company will have to find some other means of income or declare bankruptcy, in which case, the investor loses their money.
What are the Interest Rates on Convertible Notes
In the U.S., a convertible note is required to include an interest rate. Typically for a startup company on the west coast, this rate can be as low as 2% but no lower. In the east and the rest of the country, the interest is anywhere from 4-8%.
The compounded interest rate on the convertible note is added to the value of the convertible equity. When the note converts, the total of the original investment plus the earned interest brings the total equity in the company up, giving the original investor a larger percentage of ownership.
What is Meant by Discount on a Convertible Note
When a seed investor puts their money into a new company that has not yet really defined its worth, they are taking a financial risk. In order to pay them back for that risk, a discount is agreed to in the convertible note. This discount is applied on top of the interest rate, to the initial investment.
This means the convertible note will translate to more equity when the note converts or when the next round of equity occurs. The seed investor will be able to obtain more stock than the new investors for the same amount of investment.
What is Meant by the Conversion Cap on a Convertible Note
A seed investor takes a risk when they are providing capital to a new venture. A conversion cap sets the highest point at which the conversion note will be converted to equity regardless of the valuation of the company at the time.
For example, say a company has set the conversion cap at $2 million. Later, at the next equity round, the company is valued at $4 million. New investors would buy stock at the new valuation. That original investor would receive the equity amount of $4 million for their $2 million investment, thus doubling the amount of equity they receive. This also gives the seed investor a larger controlling percentage of the company.
Pros and Cons of Convertible Notes
There are many options to get funding for a startup venture. Unfortunately, the majority of these options are complicated and time-consuming. In most cases, conversion notes allow companies to quickly get the money they need to build their business. That doesn’t always come without some downfalls.
A Few Pros of Convertible Notes
Convertible notes have a simple structure. This less complex arrangement means less paperwork as well as fewer legal fees. It also means things move more quickly thus saving time as well.
A convertible note delays the valuation of a startup. When a startup is looking for funding, it is difficult to get an exact fix on the future value of the venture. A convertible note lets the company founders start the company while giving the business time to figure out its true value and future growth potential. That gives the startup time to grow and look for other additional investors. By the time of the conversion or the next round of equity, the company should have a better idea of its true value and potential.
The seed investor will have more equity after a conversion. Because of the interest rate and the discount, by the time of the conversion, the first investors will get more for their investment than subsequent investors putting in the same amount. This will also give those seed investors greater control of the company for that same level of investment.
A convertible note means less risk if a company fails. A convertible note is initially a loan that is a debt until it converts. Because of this seniority, debt from a convertible note will be paid before any partners having only equity in the company. This means the seed investors have a reduced risk of losing their money than later rounds of investors.
A Few Cons of Convertible Notes
The size of the convertible note needs to be appropriate. If the debt for the loan is too big, when it converts, it will reduce the amount of equity that can be reasonably offered to future rounds of investors. Also, because the value of the company is delayed, setting a valuation cap too high or too low can deter future investors and complicate things down the road.
Convertible note holders do not have any control over their investment until it is converted. Unlike future rounds of equity investors, investors holding a convertible note do not own stock. They own debt. Until the debt is converted to equity, they do not have voting rights or control over what is done with the company and how the equity is distributed. This scares off some potential investors.
A convertible note is a debt and must be paid back if the note does not convert. If the company does not succeed and cannot raise further capital, the loan still must be paid when the maturity date is reached. If it reaches this point, the company should discuss with their investors, the best way to proceed.
Most, if not all parties want to avoid bankruptcy. Bankruptcy would mean that the investors would get little, if any, of the initial cash investment back.
A more practical method to pay off the debt is to arrange a payment schedule. While a payment schedule means the loan would continue to accrue interest, it would also give the business more time to get additional investors and thus more capital.
Other Things You Should Know About Convertible Notes
There are a lot of things to understand about convertible notes. We have tried to cover the basics in this article. However, there are a few more things you might want to know.
What type of stock does a convertible note convert to?
When a convertible note converts, it is usually to preferred stock, not common stock. This is done to simplify things. Common stock can be issued on a convertible note, but most savvier investors will choose the preferred stock for tax purposes as well as a guaranteed, larger dividend.
What are SAFE notes?
Both convertible notes and SAFE notes were developed to benefit interested investors while benefiting the startup company.
SAFE notes do not have maturity dates or interest rates, both of which are required for a convertible note. SAFE notes do contain valuation caps. These are simple five-page documents that are often preferred to convertible notes because they are not debt and therefore do not accrue interest. The document is also very easy to draft and could save even more on legal fees if you are brave enough to write your own.
SAFE notes were launched in 2013 by the Silicon Valley accelerator Y Combinator. In general, they are not used with an LLC (Limited Liability Corporation) but instead with a company with a C-corp status. In other words, a company must be incorporated if they want to use SAFE notes to raise funding.
Types of SAFE notes:
- Cap, no Discount
- Discount, no Cap
- Cap and Discount
- MFN, no Cap, no Discount
How about KISS convertible notes?
Yet another instrument to attract investors and accelerate the funding process, KISS documents were developed by 500Startups, an organization similar to Y Combinator. It is more complex than a SAFE note, but at the same time, more balanced.
A KISS convertible note or Keep It Simple Security is very similar to a traditional convertible note. However, it has a 5% interest rate and a set maturity date of 18 months. KISS automatically converts to preferred stock when the equity reaches $1million.
There are two types of KISS notes:
- Debt KISS notes
- Equity KISS notes
Debt KISS notes contain a maturity date and interest rates.
Equity KISS notes do not accrue interest nor have a payment schedule.
What is an MFN clause?
A Most Favored Nation clause in this case refers to a convertible note and not a country. An MFN ensures early investors have the same rights and terms as later investors. This is an unusual addition to a convertible note, but it is becoming more popular. One of the main benefits of an MFN clause is that it protects first-time investors against losing advantages that more experienced and probably bigger investment companies would have.
The Bottom Line to Convertible Notes
The world of investing can be complicated. Trying to raise money for your startup can be daunting and overwhelming. Convertible notes are a mix of debt and equity that can be renegotiated in future equity rounds. They present less risk and are quicker than issuing and selling stock in a new venture. Convertible notes allow a startup to attract investors while giving themselves space to breathe and focus on building their dream company.