One of the greatest struggles for a startup is valuation. How do you place a value on something that you’re still building? This challenge can slow down startups who may think seeking venture capital is the only way to scale their business quickly. If you’re one of these early stage founders, a convertible note may just be the answer for you.
What is a convertible note?
A convertible note is a debt instrument often issued by angel or seed investors looking to fund an early stage startup that has not been valued explicitly. After more information becomes available to establish a reasonable value for the company, convertible note investors can convert the note into equity.
The firm valuation will usually be determined during the Series A financing round. Instead of a return in the form of principal plus interest, the investor would receive equity in the company. If the company fails after issuing a convertible note and defaults on its obligations, its note holders will probably be unable to get their initial seed or investment back. If there is anything to collect, convertible note holders fall in line after secured debt holders and before shareholders.
Basically, they are short-term debt instruments that will convert into shares of stock when a conversion event (detailed in the note agreement) occurs. This type of borrowing is widely used in the early stage(s) of a company’s lifecycle. The investor(s) understands that the it is more likely that the principal and related accrued interest will be converted into shares of the company and not likely paid back in cash.
How are convertible notes accounted for?
Even though the note eventually converts into stock, it will be carried on your balance sheet as a liability (debt). The related interest will accrue and is typically not paid through the term of the note, so there is no adverse impact on company cash flow. From the founder’s perspective, convertible notes essentially behave like a stock. That’s a win-win for both investor and startup.
Another benefit of convertible notes is how simple and fast the process is. Usually it only takes a day or two and there is no dilution, no taxes on shares or on the debt that you’re raising (to the company or to investors), and no valuation process is required. Convertible notes are so widely used that the forms are largely standardized. This makes the process quicker and less expensive (fewer legal fees).
How are convertible notes structured?
The agreements are short in length (usually two to three pages) and easy to draft. The process is quick and almost casual. A round of fundraising can take anywhere from between three and six months, while a convertible note agreement can happen within days.
Convertible note agreements are typically unsecured, and because there’s no valuation, there are just a few terms that need to be negotiated – interest rate, term, and discount being the most common.
Angel investors are most likely to utilize convertible notes as a form of investment in early-stage companies. They are often more interested in your idea, concept, or your business plan and less concerned about your current status or valuation. They have their eye on the equity conversion and your potential. Convertible notes can be used to raise capital in the short term and build a company that will attract VCs.
Because you’re not dealing with a big bank or institution, convertible notes are flexible. Unlike a lender, an investor is interested in helping you succeed. So, terms can be added or deducted if both parties agree.
How to get started
As mentioned above, convertible notes are simple.
- Determine the amount of capital you need
- Pitch the note terms to an accredited investor (this is like any investor pitch)
- Negotiate and agree to the terms
- Draft and sign the documents (the note purchase agreement for company and investor and the note for the company)
- Exchange executed note purchase agreement and note for the check or wire
Ready to jump into the pool of convertible notes? Before you dive into debt (even debt that converts to equity), consult with your lawyer, tax advisor, and board of directors.
As you do your research, you’ll likely find information about SAFE and KISS agreements, which Y Combinator is known for using. These newer methods have evolved from convertible notes, but in our experience aren’t as widely adopted. Certainly, explore all of your options and choose what’s best based on your specific goals and needs.
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