Startup Fundraising 101: Convertible Notes

Deciding how to finance your high-growth startup company is important. Most startup companies rely on outside sources of financing, and there are many forms of capital that investors can provide. One of these forms is a convertible note.

What is a Convertible Note?

Convertible notes are a hybrid between debt and equity, with the initial structure being a debt investment. These notes have a provision that allows, at a later date, the principal and accrued interest to convert into an equity investment. This structure is beneficial because the original investment can be done faster and is cheaper due to lower legal fees, but allows the investor to receive the economic benefit of an equity investment.

Components of Convertible Notes

There are several components that make up a convertible note. These components include:

Maturity Date: Convertible notes have defined maturity dates, which makes the note due to the investor if the note has not been converted to equity. In some cases, notes are automatically converted at maturity.

Interest: Like every other debt investment, the funds in a convertible note produce a rate of interest that accrues over the life of the note.

Conversion Provisions: The most common method of conversion happens when qualified financing occurs. Qualified financing is when a certain threshold is exceeded by a subsequent equity investment. At this moment, accrued interest plus principal converts into shares of the new equity that was just sold. This typically provides note holders with more shares than they would have received if they waited for the equity round of financing.

Conversion Discount: Investors usually receive a discount on the price per share of the new equity purchased after a qualified financing event.

Valuation Cap: A hard cap on the conversion price for noteholders, regardless of the price per share on the next round of financing. Conversions that occur automatically on the maturity date are usually lower than the valuation cap.

Pros and Cons of Convertible Notes

Pros:

  • Since seed-stage companies do not have enough operating experience to properly evaluate the company, convertible notes avoid placing a valuation on the company
  • Good bridge-capital financing options
  • Less expensive and faster to execute because they are simpler to legally document

Cons:

  • Companies could be pushed into bankruptcy if future equity rounds do not occur because the note will still be redeemed as debt
  • Price expectations from valuation caps could complicate future equity rounds
  • To avoid the issue mentioned above, terms and conditions can be set for convertible notes. This may defeat the purpose of the convertible note and end up taking as much time and effort as equity financing

Convertible notes encompass the best attributes of both equity and debt investments. If utilized properly, they can be a powerful method to raise capital, but it is important to understand all of the implications of convertible notes. Startup companies should weigh all of the pros and cons of all investment options to determine which one is best for fundraising. Contact an Anders advisor with questions on how convertible notes can help fund your startup company, or learn more about the Anders Startup Group.

Learn about other types of fundraising options in our post on Startup Fundraising 101: Fundraising Options.