What is a Convertible Note?

What is a Convertible Note?

A convertible note is essentially a form of short-term debt that, over time, is repaid to the investor as equity in the company, rather than in principal plus interest. This is a strategy commonly adopted by startups and entrepreneurs who are looking to gain funds without going through the complexities of bank loans and overdrafts.

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:

Advantages:

  • No need for investors to determine the value of the business, as 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, as noteholders will not be provided shares upfront.
  • As noteholders will not be provided shares upfront, there is no immediate paperwork that needs to be completed, in relation to raising equity. For example, there is no need to notify the Australian Securities and Investments Commission (ASIC) until equity is being raised.

Disadvantages:

  • Prudent investors may prefer to invest in companies that clearly outline their investor rights, and that has been historically fair in their terms and pricing.
  • 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 as to the terms and parameters to consider when determining the value 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. It is important to note that interest is measured through application of the simple interest method, or the compounding interest method.

2. Discount Rate

The discount rate is essentially a reflection of the amount of risk that the investor took, in investing in your business. For investors who invest in a given round, they will ordinarily be provided with a discount rate in subsequent financing rounds.

For example, if a noteholder invested $250,000 on a convertible note with a 20% discount rate, this will mean 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 essentially sets the threshold in which investments made, by virtue of a convertible note, can be converted into equity. This can be extremely beneficial for investors, as a lower valuation cap will mean that the noteholders will have a considerably high stake in the business.

For example, if 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. As constantly referred to through this article, convertible notes are most appropriate for start-ups and entrepreneurs who are willing to incur future financial detriment, in order to get their business off the ground. Though this detriment might sound dreary, the terms of the convertible note, as discussed above, can be altered and tailored in a way that benefits both you and your shareholders.

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. 

If you need any assistance in determining the best way to raise equity for your business, feel free to contact us at 1300 337 997.

About Daniel Katz

Daniel KatzDaniel is a legal intern at OpenLegal, placed in our legal content team. He is currently studying a Bachelor of Laws at the University of Technology Sydney. Daniel's interest lies in economics and media/startup law.