What Is a Convertible Note?
Simply put, a convertible note is a particular type of short-term loan that has the potential of converting into a stock.
In the case of ordinary loans, the borrower repays both the principal and the interest at the time of repayment. In contrast, in a convertible loan, the lender can receive a portion of the company’s stock instead of money.
Convertible Note Applications
This method of financing is widely used for startups in the early stages or the ones with low capital requirements. Furthermore, a convertible note is one of the best options for financing when the startup needs to attract capital instantly.
Convertible loans become especially important when the startup valuation process is challenging. There are startups with great ideas that need to raise capital. However, at the seed stage, they do not have any shares to transfer to the investor. On the other hand, it is not possible to evaluate them. The convertible note is a method of raising capital that saves such founders.
On the other hand, when the founders and the investor disagree on the startup’s valuation, the convertible note makes financing possible by postponing the valuation to the next round of raising capital.
Using a convertible loan, the investor provides the required capital for the startup. If the startup succeeds, it can receive the startup’s stock instead of the principal and interest of the money.
Here are the benefits of this financing method and its tools.
Benefits of Raising Startup Capital Through Convertible Loans
The main advantage of financing through convertible note is its simplicity, speed, and low cost. However, we can add the following:
Postponing the Startup Valuation Process to the Next Round of Capital raising
When a startup uses a convertible note instead of receiving capital in a stock exchange, all valuation discussions and meetings are postponed to the next round of capital raising. As a result, startups can quickly raise the capital needed to market their products and services. In this way, the startup can attract the user and create the historical data needed for valuation, including sales and revenue. However, In the next round, when venture capitalists and strategic investors enter the playground, they can evaluate the startup based on stronger assumptions. As a result, more realistic valuations will be made.
In the next steps, when a prominent investor (or venture capitalist, VC) invests in the startup, holders of a convertible note slip can convert it into stock. They receive rewards for their early investment risk by receiving shares from a successful startup that has attracted the attention of larger investors.
“Eliminating startup valuation discussions and negotiations means a better chance of negotiating and financing at the time.”
Speed up the Deal and Spend Less Money
When a startup relies on various sources for financing, such as angel investors or venture capitalists, it is usually very challenging to conclude and close the contract. Different investors have different demands and different legal structures. While a convertible note is accepted as a standard, it is relatively easy to agree on. The contract is usually only between the startup and the investors and does not involve formal registrars, so financing is done much faster and at a lower cost. The total time allotted for negotiating and agreeing on a convertible note is usually one week, while agreeing to grant shares may take months.
Financing through convertible notes can be done faster and at a lower cost due to the standard format.
Maintaining Control of the Startup
At the time of stock transfer to investors, they usually claim numerous rights from the founders via the shareholding memorandum, including the right to attend board meetings, veto decisions and the right to decide to sell the company.
However, according to Fenwick & West, only a tiny percentage of convertible notes receivers granted such rights to the investor (or lender). Therefore, the founders can maintain control of the company by receiving a convertible loan.
Convertible notes prevent investors from gaining control of the company when the startup is in its infancy.
Convertible Loans Benefits for Investors
Beyond being helpful for founders, convertible notes loans have many benefits for investors, some of which are discussed below:
It Maintains Different Tools to Increase the Investor Return Due to Accepting More Risk
In direct stock trading, the investor receives a profit only if the stock price rises, while if the stock value falls, he loses. But different tools in convertible notes – regardless of share price – can increase the return on investment and make its use more attractive to investors. Here are three tools in convertible notes that lead to higher returns for the investor.
In a convertible loan agreement, a number is considered as the interest rate. This interest rate is compounded over time, and capital gains can be converted into stocks. Therefore, the investor can receive more shares without injecting more capital. For example, if the interest rate on loan is set at 20 percent per annum, after two years (at the time of raising the next round of capital), the investor can receive shares 40 percent more than the initial numbers he could buy.
Using this tool, the investor can receive a discount on each share when converting the convertible note into shares. In fact, this discount is provided to the investor due to accepting higher risk and investing in time.
For example, suppose the discount provided in the contract is 30%. In this case, after attracting capital in the second round, the base value for calculating the investor’s stock will be 30% less than the calculated value. This means that the investor can receive the startup shares at a lower price than the market price.
The cap In a convertible loan sets the final value limit before the startup can raise capital at the time the loan is converted into shares. This becomes even more important when a startup is a huge success.
For example, if the cap set on a convertible loan is $ 2 million, but the startup raises capital based on the value of $ 3 million in the next round, the investor’s shares are calculated based on $ 2 million.
In addition to contributing to the success of the startup, in this way, the investor will earn more profit due to receiving a higher percentage of shares – through a discount or a ceiling on value.
Investor Easier Exit
In typical circumstances, only at the liquidity event, the investor can withdraw his capital from the startup. However, on a convertible note, the investor can get his principal back on the maturity date if the startup is able to repay the amount. This option notes provides more flexibility in repaying the principal amount than stocks.
The maturity date for a convertible loan is the deadline for the next round of startup capital raising. On this date, Inverter can convert the loan into shares. However, if capital raising fails for any reason, the investor has the right to withdraw his capital from the startup.
Which of the Parties Is More Interested in a Convertible Note?
The main advantage of convertible notes for startups is raising the capital required without going through the valuation process. Investors can also hedge their risk by using discount tools, valuation caps and get startup stocks at a lower price.
This kind of loan provides an opportunity for startups to raise capital even in the very early stages. Initially, the money enters the startup as a loan and can be converted into shares in the future. The conversion of loans into shares occurs under certain conditions that can maintain the investor’s investment value.
However, when using a convertible note, founders should always note that it is a kind of loan. Consequently, if the investor requests it, the founders are obliged to repay it. This may affect the next rounds of startup capital attraction by making investors hesitant.
The Convertible Note Contract Components
As mentioned, a convertible note is a type of loan with an interest rate. Unlike traditional loans, this interest is paid in shares instead of cash.
The date on which loans, bonds and other debts are settled. The investor can ask for the loan and the interest, even if the startup’s financial situation is vulnerable. In fact, one of the disadvantages of this type of loan is that the lender can receive the principal and interest at the maturity date. However, many startups do not have enough financial resources to repay on maturity. Sometimes this leads to startup liquidation.
One of the essential clauses of the contract is determining the conditions under which the loan will be converted into shares. One of the most common conditions is the startup financial competence. If the startup can raise sufficient capital, the loan will be converted into shares. However, if not enough capital is raised, the investor can decide about it.
Other clauses that are common in this contract are:
- Details of the parties to the contract, including the lender and the borrower
- Contract Subject
- Term of the contract
- Obligations of the parties, including the lender, the borrower and other shareholders
- Confidential information
- How to resolve disputes and the law governing it