A convertible note is a form of short-term debt that is repaid to the investor as equity in the company, rather than in principal plus interest. This is a strategy commonly adopted by startups.
Importantly, the note is converted into equity depending on particular, catalysing circumstances. In most circumstances, this occurs when a future equity investment round closes.
Here are some pros and cons to issuing convertible notes:
- No need for investors to determine the value of the business. This is because convertible notes are often issued when the business is merely an idea.
- You will be able to maintain control and ownership of your business for longer. This is because noteholders will not be provided shares upfront.
- As noteholders will not be provided shares upfront, there is no immediate paperwork. For example, there is no need to notify the Australian Securities and Investments Commission (ASIC) until equity is being raised.
- Prudent investors may prefer to invest in companies that clearly outline their investor rights.
- Can be financially consequential for investors if the notes are uncapped (to be further discussed).
- There may be capital issues if the investor requests a conversion in circumstances where your business is experiencing financial distress.
Terms of a Convertible Note
Startups and small business should be wary of the terms of a convertible note:
1. Interest Rate
As convertible notes are a form of debt, it is more likely than not, that the note will accrue interest. Additionally, interest is measured through application of the simple interest method, or the compounding interest method.
2. Discount Rate
The discount rate is a reflection of the amount of risk that the investor took, in investing in your business. Investors who invest in a given round will ordinarily be provided with a discount rate in subsequent financing rounds.
For example, say noteholder invested $250,000 on a convertible note with a 20% discount rate. This means that they will receive a 20% discount on share-prices in subsequent rounds (ie. $1.60 instead of $2.00).
3. Valuation Cap
The valuation cap sets the threshold in which investments made can be converted into equity. This can be beneficial for investors. In essence, a lower valuation cap will mean that the noteholders will have a considerably high stake in the business.
For example, say an investor makes a 5 million-dollar investment in your firm, and later your business receives a valuation cap of 100 million dollars. That investor would own 5% of the business. Conversely, if the company received a valuation cap of 50 million, the investor would own 10% of the business.
4. Maturity Date
As with all loans, convertible notes have maturity dates which indicate when the note will fall due for repayment.
Who Should Issue Convertible Notes?
Convertible notes should not be the go-to method of raising equity for every single business structure. To reiterate, convertible notes are most appropriate for start-ups who are willing to incur future financial detriment, in order to get their business off the ground.
To Wrap Up
Raising funds as a start-up is perhaps one of the most important, and difficult, tasks in ensuring future success. Convertible notes certainly have their benefits, but they may not be particularly attractive to prudent investors.
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