Though convertible notes are now part of funding currency for investors and entrepreneurs, and most appreciated for their expediency and simple premise, it doesn’t mean they don’t come with their own risks. A convertible note is essentially a debt instrument that allows angel investors to loan out seed money into (usually) early stage startups, which can be later converted into equity or be paid out, with accrued interest, at a mutually agreed upon time, or during the next round of funding.
These are often preferable to traditional methods of purchasing equity because a loan can be paid out without a proper valuation on a startup, without lawyers fees, and can be issued much more quickly. Here are some things to know about the convertible note.
Discount on Shares
Typically, the agreement of a convertible note grants the investor to the loan, plus accrued interest, and a discount on shares if they wish to stay with the company. The discount rate is an extra provision that allows investors to compensate for the additional rate they’ve taken for investing in an early stage company.
A discount rate is set by the investor and founder, but they typically range between 15% – 30%, which means that after the Series A round of funding, when new investors are investing at, for example, $1 a share, than original investors can cash in their convertible note at 15% – 30% less than that (so $0.70 – $0.85 per share, depending on the discount).
Advantages of the Convertible Note
Convertible notes carry many advantages for investors and founders who can play smartly. A common problem when negotiating funding is actually reaching a valuation, and a convertible note can be issued and later converted into shares of preferred stock when a proper valuation can be established and the founders are at the next stage of financing.
This simple and relatively quick way of early funding delays most of the complex terms involved in negotiations, and can save the founder the hassle, and exorbitant fees, of going through a lawyer. It also protects the investor and founder of future dilution, tax complications, and control issues, because a convertible note is considered a loan, not equity.
Disadvantages of the Convertible Note
A founder who is hammering out a deal for a convertible note might want to consider the size of the convertible note. If it’s too large, it may convert to a large share, and crowd out potential investors from having the equity share they would like in the next round; or too much convertible debt may overburden the founders upon conversion.
If a cap is too low, there may be further dilution after surpassing the cap during the next, larger round. Another concern to weigh is whether or not a convertible note really will pay off in your favor after it converts: convertible notes give note holders the same investor rights as future investors, which can mean Preferred Shares, a board seat, veto rights, and minority stockholder rights. In some cases, the founder might have benefited more from just selling equity for ordinary shares right off the bat.
Capped Versus Uncapped
A valuation cap is increasingly becoming a standard term of convertible notes, particularly for bigger investors (as the company’s value can often increase by the reputation of its investors). It’s a provision that protects the investor and allows investors to put a ceiling on the conversion price of the note and, therefore, benefit from any increase in the value of the startup.
For example, if the agreed-upon cap is listed at $5 million, but the pre-money valuation in the Series A round of financing comes out to $10 million, the note can convert into shares of preferred stock at $5 million. However, as these projected valuations are not actual valuations, the company has some flexibility as to how to price the caps.
Provisions to Help Investors or Entrepreneurs
Not all convertible notes look the same. Certain provisions can be negotiated that can benefit either the entrepreneur, or the investor, or both. Some convertible notes allow companies to prepay their note before it converts, which is not attractive to investors because they might only get interest on their loan, as opposed to a proper return.
However, it is possible to add a provision that will allow a prepayment before conversion to happen only upon approval by a majority of the holders of the principal amount of the notes. Some convertible notes allow founders to repay their notes plus accrued interest if the company is sold, but with a provision that allows the investor to get back their money, with interest, as well as a premium before the note converts – this usually accounts for 1.5 to 2 times the principal. By taking the time to go over these provisions, a founder and an investor can come to a mutual agreement to better maximize their deal, without leaving anyone behind.