What is a Convertible Note and How Does It Work? Startup Capital 101

There are lots of ways to attract investors and get the funding you need to secure success as a startup or small business . Most entrepreneurs rely on traditional investment rounds by referencing data on their company’s profit margins or production estimates to get investors to offer cash in exchange for shares in a company. However, many entrepreneurs are more frequently using convertible notes. These are essentially short-term loans that trade future company equity in exchange for cash now.  Let’s break down these somewhat-complex debt instruments and examine how they might be a beneficial choice for your startup’s investment needs.

What is a Convertible Note?

When you start a new company, you need a lot of capital in order to get the ball rolling and to purchase the infrastructure and talent necessary to actually start producing a profit. The only trouble is that many new startups don’t have the cash on hand to get things started. That’s why a lot of new startups or small businesses leverage various capital-raising techniques in order to attract investors before expanding. By attracting financers and investors, companies can acquire the capital they need to grow and reach their maximum productivity before actually making a big profit. Then they pay the lenders or investors back progressively. A convertible note is a type of short-term debt financing. It allows small businesses or startup entrepreneurs to offer a kind of delayed equity to potential investors instead of offering them a direct share of the company immediately. Think of it as a kind of startup “IOU.” More specifically, convertible notes are short-term loans that offer investors stakes in a company at a later date. Basically, the loan converts into capital or equity in the company (equity being a piece of ownership, similar to regular stocks on the stock market). 

How Do Convertible Notes Work? 

If a company decides to issue convertible notes, they create a variety of notes for different investors that come with certain repayment terms. Repayment terms will include:

• The due date that  describes when the note "matures" – this is when the balance of the note is due
• How much equity or stake in a company the note represents. This is usually equivalent to the initial investment in terms of cash, plus a little extra
• The interest rate – after all, every loan has an interest rate so the lender has a reason to hand out their money in the first place

The big difference between convertible notes and regular startup capital methods is that convertible notes don’t repay the investor in cash. Instead, an investor is repaid with equity in the specified company. For instance, say that a startup needs $100,000 of cash in order to expand their operations. An investor could accept a convertible note in exchange for providing the $100,000. Around a year later, the note matures and the investor gets $110,000 (assuming a 10% interest rate) worth of company equity, which may equate to a certain number of shares. To make things even more attractive for a potential investor, most of the debt-equity in convertible notes is heavily discounted relative to the equity priced for investors that come in at a later date. For instance, a convertible note may get shares or pieces of company equity priced at $100 a share. Any later investors may need to pay $200 a share. Again, this rewards early investors for getting in on the proverbial ground floor. Note that, in general, convertible notes are used as a prelude to a more traditional round of funding or investment. It’s a way to get investors excited and interested in a startup company before that company has a lot of value. Furthermore, it’s a way to attract investors who want some say or ownership in a company. After all, many investors only like to fund enterprises that they feel personally attached to rather than companies they can make a quick profit out of via interest.

Benefits of Using Convertible Note for Startup Capital

Many entrepreneurs and startup executives opt to use convertible notes for their startup capital needs due to their varied benefits.

They’re Quick and Easy to Issue

Convertible notes, particularly compared to traditional rounds of investment or funding, are quick and easy to issue. They don’t have the same complications included in regular price rounds of funding, during which companies have to actually issue shares of their stock. Instead, convertible notes act as easily defined short-term loans for debt. This allows company owners or other investors to determine the exact valuation of the note at a later date. All that has to remain consistent is the equity's value – it must stay proportionate to the initial investment.

They Help Owners Actually Retain Ownership for a While

Many company owners are uncomfortable with investors coming in and getting lots of say over their company’s operation just because they need funding . While it’s almost impossible to retain sole control of a company if you want to reach a certain amount of funding flexibility, convertible notes allow owners to retain control over their companies for a while longer. That’s because they don’t have to issue actual shares with their convertible notes. Instead, they get investment cash and promise to give investors equity or company shares at a later date. Depending on the startup and the nature of its operations, this could be crucial for maintaining company identity or overall direction in its early years.

Delays Valuation

One of the smaller benefits of convertible notes is that it allows companies to delay valuation. For companies that have relatively unproven concepts or products to provide, this can be advantageous since it prevents investors from writing them off entirely. For instance, say that your company makes a new type of computer chip that you believe is going to reinvent the IT industry. But if no one else in the industry believes you, your company won’t be valued very high if you try a traditional funding round of investment. Convertible notes allow you to gain the capital you need to expand and really prove your idea without having to put solid numbers to or “value” your company in a concrete way. You can value your company later once you have actual numbers and profit margins to show two new investors. However, note that even though convertible notes may offer a number of benefits to initial investors, they can actually turn future investors off to some extent if they know the details of your initial equity pricing. They may feel misled or unnecessarily upsold when they try to buy company equity for much greater prices than their early bird counterparts. Thus, it’s important to navigate convertible note distribution and negotiation carefully and gracefully.

Important Terms to Know

The terms in a typical conventional note can be dense. Let’s break down a few of them so you’re prepared.

• Valuation cap – this is the total value at which the investor’s loan converts into equity. In general, the lower this cap is, the better it is for the investor since they can get more equity in your company for lower prices
• Maturity date – this is the date at which the note converts into equity and a business owner needs to repay their investors for their loans
• Discount rate – this is the comparative discount that convertible note investors get relative to traditional investors
• Interest rate – this is the interest rate for the loan. These are usually quite low since most investors are interested in getting equity in your company, not making a direct profit

All of these terms will need to be negotiated and agreed upon before issuing a single convertible note. Different investors may also have different requirements or requests.

Who Are Convertible Notes Good For? 

Overall, convertible notes may be good options for startups that don’t want to unnecessarily or rigidly value their company just yet, as would be necessary with a traditional round of investment (during which you have to value and issue regular shares). Furthermore, convertible notes might be a good choice for companies that need investment fast and who don’t have the time or information available to issue traditional stocks or shares. Lastly, companies whose owners want to retain more control for longer may look into convertible notes and only give up greater control of the company once its direction has been more permanently set.

Summary

In the end, convertible notes are just one more method of raising the capital necessary to find success . Many entrepreneurs are now using convertible notes as opposed to other funding methods due to their flexibility, ease of distribution, and other benefits. But you should think carefully before using convertible notes for your own startup funding. Need some insight? Don’t hesitate to contact Seek Capital for all your questions regarding funding, financing, and finding loans for your small business . Sources https://medium.com/@taw/valuation-caps-ee7918aa6d13 https://immixlaw.com/what-is-a-convertible-note/ https://www.toptal.com/finance/startup-funding-consultants/convertible-note