Convertible Notes: Benefits and Drawbacks (Explained)
Seed funding empowers startups to begin full-fledged operations and processes. Some of the ways start-ups raise funds are through angel funds, venture capitalists, sharing equity with investors, or borrowing from friends and family.
Now, these types of fundraising may work well for startups with a strong reputation, a great marketing pitch, and a reasonable company valuation. But for early startups, issuing shares or equity may not be possible at this stage of their venture.
So, after crossing the personal investment stage, startups usually seek convertible notes for their first external funding round. This article will guide you on the pros and cons of convertible notes and how you can tackle their drawbacks.
What are Convertible Notes, and How do they Work?
A convertible note is when an investor gives money to a startup and receives equity from the company in return. But how do convertible notes differ from a loan? When an investor lends capital (loan) to a startup, the company will have to pay the investor principle and the accrued interest.
In the case of a convertible note, the principal amount and the interest will be converted into equity in case of an event referred to as a “trigger event.”
Please note that trigger events are predetermined.
An example of a trigger event is when a business reaches the next qualifying round where it has significantly grown and can share equity and rights with the investors.
Initially, the company could only treat investors as someone who loaned them capital for the business. However, after achieving the terms or goals mentioned in the convertible note, the company can convert the loan amount to shares, thereby giving more rights to investors.
Although convertible notes do not require any valuation for acquiring a loan from the investors, it lays a firm base for future funding rounds based on company valuation.
6 Benefits of Convertible Notes that Make Them Worth It
Convertible notes can benefit a startup, giving the company more time and energy to focus on growth and bringing potential returns for the investors. Here are some ways:
1. Higher efficiencies with lower risks
Many startups in the seed funding stage may not be able to perform company valuation as the company may not have taken full fruition to reflect a definitive value. Therefore, this type of funding eliminates the risk of incorrect valuation.
Convertible notes have a straightforward structure. A convertible note is a form of debt that does not require creating a second class of shares or issuing common stock as most initial fundraising models go. This eliminates complications from company valuations like stock option grants and related tax implications.
A well-drafted convertible note allows entrepreneurs to decide how the note must be redeemed when a trigger event occurs. The investor can either take shares in the company or have the note repaid in cash.
3. Discount rates
If an investor invests in the company without proper valuation, they can take shares at a discount rate in the future as a reward. Usually, investors take more shares when negotiating a discount. Most discount rates are negotiated at 5-30%, with 20% the average price.
4. Interest rate
The investors can also negotiate an interest rate where the company pays interest periodically during the tenure of the convertible note. Or, the interest rate can be accrued over time and paid in full when the trigger event occurs.
5. Valuation cap
Adding a valuation cap to the convertible note can set a maximum price at which the note converts into equity or shares. When there is no valuation cap, the chance of getting good returns from the equity if the company’s value skyrockets are significantly less.
As an investor, you can secure your investment with property owned by the company or guarantor. This gives you more security in liquidation or if the company becomes insolvent.
2 Major Drawbacks of Convertible Notes
Convertible notes are often a double-edged sword due to their unpredictable nature and the lack of control for investors over business decisions.
To steer clear of the pitfalls of convertible notes, both startups and investors must be aware of their drawbacks to tackle them efficiently.
Here are a few disadvantages of convertible notes and how they can be solved:
1. Limited control
While convertible notes allow startups to get funding without a company valuation, this may deter investors from investing in the company. In addition, investors and entrepreneurs can find it challenging to determine if the terms of the convertible note are fair and may not find convertible notes assuring or secure as a normal investment.
Investors may be willing to pay a higher price for shares in a company after it has grown large enough to be evaluated.
Another reason why investors may hesitate with convertible notes is because they forgo their rights to make company decisions as they will not be shareholders until the note is converted.
Shareholder rights like voting rights, control rights, pro-rata rights, and liquidation preferences do not apply to an investor. In addition, they do not promise long-term capital gains until the note is converted.
Investors may not always be sure if the company can ultimately raise the expected equity financing in the startup’s beginning stages. As a result, there is always a risk of the company facing bankruptcy or heavy debt.
Most companies in such adverse situations will be forced to take up more loans to pay off the investors. Sometimes, companies do not pay the investors, which can be a significant loss as notes do not need clauses that auto-convert on maturity.
To ensure that investors negate the uncertainty and ambiguity of convertible notes, experts suggest using a convertible notes management system that addresses all terms and conditions of the convertible note agreement with an automatic conversion clause. This helps to avoid unpleasant situations between entrepreneurs and investors.
trica equity for Successful Engagement with Convertible Notes
Fundraising is quintessential for startups. Convertible notes are becoming popular among angel funds and traditional venture capitalists to invest in companies even if they cannot perform a company valuation in the beginning stages of their business.
trica equity Management systems can help startups digitize how to manage their shares equity and build in ready-to-use notifiers to manage conversions on such instruments in a more seamless manner. trica makes equity transactions easier and helps you find investors for your venture.