Convertible Notes for Startup Financing

Convertible Notes for Startup Financing

 

If you’re planning a seed round raise you need to know your way around convertible debt: what it is, how it works, and what the benefits are. While investors in some less well-developed startup hubs are still largely resistant to using convertible notes and some angels prefer priced rounds, according to SEEDCHANGE’S Kevin Smith, 93% of early-stage rounds in coastal startup hubs use convertible notes.

So what are convertible notes exactly?

Essentially, notes are debt that acts like equity. They function as legal IOUs but with repayment in stock instead of cash. That said, convertible notes must have certain debt features such as interest rates and maturity dates. More on those later.

Key features of convertible notes:

Key Convertible Note Terms

If you’re in talks with a potential investor who will only do a priced round and not convertible notes, base your decision to move forward on whether the investor will be a good fit and whether s/he is offering a meaningful investment.

So far so rosy. But there’s always a catch…

Two features of converts that are often criticized and misunderstood are the discount and the cap.

When it comes to terms, try to negotiate a number for the cap that both sides can view as “fair;” $4-$4.5 million is about right for an early-stage company.

If you’d like to see how these conversion scenarios work in practice, fill out this form for a free download conversion scenario template:

How to set yourself up for a successful raise:

Before you start pitching investors, figure out your fundraising game plan including how much you need to raise. And figure out the minimum you want to accept from each investor. At the seed stage, the total raise is $500,000-$1,000,000. Typically your raise will involve four investors putting in $250,000 each. If check sizes are lower than this, the administrative hassle increases.

Next, get ready for due diligence. Know and be prepared to discuss how much you want to raise and what you plan to use the funds for. Practicing milestone funding: by identifying discrete goals and setting realistic timeframes to achieve them not only helps your execution, it also sets the stage for large increases in valuation down the road when it’s time to raise more funding.

Although the process of completing your raise might stretch to six months, the timeline with each investor that you do a deal with should be relatively short and straightforward. And you can start putting investor funds to work right away as soon as you close deals with each investor. Don’t forget to update your cap table to include each noteholder you bring on.

For more insight on convertible notes from Kevin Smith and Gadiel Morantes, Chief Strategy Officer for Early Growth, access the presentation deck on slideshare.

Whether it’s your first 409a valuation or your annual update, hiring a qualified professional who can guide you through the process, explain the nuances, and will guarantee its product, is your best bet.

Do you have more questions on valuation or need assistance with startup financing? Ask us in the comments section below or contact Early Growth Financial Services for a free 30-minute financial consultation.

Deborah Adeyanju is Content Strategist & Social Media Manager at Early Growth Financial Services (EGFS), an outsourced financial services firm that provides small to mid-sized companies with day-to-day accounting, strategic finance, CFO, tax, and valuation services and support. Prior to joining EGFS, Deborah spent more than a decade as an investment analyst and portfolio manager with leading financial institutions in New York, London, and Paris. Deborah is also a Chartered Financial Analyst (CFA) charterholder.

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