Early-stage startups often struggle to raise funding from venture capitalists. Although seeking access to credit in the form of a bank loan is an alternative, this is not always a viable option for a young business.
This is where convertible notes serve as a hybrid debt-meets-equity model solution.
They allow startups to meet their immediate funding needs without the stress of having to make monthly interest plus principal payments, as is the case with business loans.
In this blog, we deconstruct convertible notes, their pros and cons, and how early-stage startups can benefit from this model.
What are convertible notes?
Convertible notes are short-term debt instruments that convert to equity at a later date.
Seed-stage startups typically leverage them to raise funding from investors without immediately giving away ownership equity.
However, unlike a regular bank loan, the startup is not required to pay back the investors.
Generally, the investors receive company shares at a later date based on the terms and conditions of the convertible note.
Significance of convertible notes
When investors offer to fund a startup in exchange for equity, they need to arrive at a mutually accepted valuation of the business. Several data points are considered during the process of evaluating the worth of the startup. This may include revenues, assets, liabilities, and profits, to name of few.
However, early/seed-stage startups have certain limitations. Some may be at the idea stage, while others may not yet generate revenues or profits. Hence, it may be challenging to arrive at an evaluation for the business.
If the company aims to raise funding through convertible notes, then there is no requirement for establishing the startup’s valuation.
On the other hand, startups that are more advanced in their journey can opt for a mix of equity and convertible notes.
Basics of convertible notes: An overview
Convertible note agreements come with specific terms and conditions. Here is a snapshot:
Interest is accrued
Like any debt instrument, the funds are received by the startup at a rate of interest. However, the interest is not paid in cash. It is accrued, and the increased value impacts the equity the investor receives in the future.
There’s a maturity date
The contract comes with a maturity date, after which the investor is compensated in cash or equity shares.
Establish conversion provisions
A common approach to conversion occurs when the startup raises capital in its next round.
The principal plus accrued interest gets converted into shares for the investor. If the startup does not find new funding, the conversion can happen after maturity.
Fix the conversion Discount
Besides receiving equity equivalent to the value of the principal and accrued interest, investors can often get a discount on the share price, and can thus get more shares.
Fix a valuation Cap
This is a predetermined hard cap on the conversion price when the conversion takes place.
These terms safeguard the interests of the startup, so they do not give way more equity than necessary.
5 Key benefits of convertible notes
This instrument comes with five main advantages as follows:
1.No need for a valuation process
One of the top advantages of opting for convertible notes is that startups can entirely skip the valuation process, which can be time-consuming. It also requires the intervention of external stakeholders.
2.No instant dilution of equity
Founders always aim to retain as much equity as possible. More ownership gives them more control over the terms when they raise funds in the future. By opting for convertible notes, they can access funding without diluting equity.
3.Speed of transaction
Fundraising can be a prolonged experience that can take months to years. For instance, it takes a significant amount of time for the investors and founders to arrive at an accurate valuation.
On the other hand, startups can close convertible note rounds in 24 to 72 hours. Even bank loans can take much longer due to the various processes and checks involved.
4.Simplicity of the process
The process of a convertible note round is considerably simple. The borrower startup can issue a promissory note and close the deal.
A promissory note is a legal lending document stating that the startup will repay the investor in the form of equity later. This is a legally-binding document.
The legal fees for putting together a convertible note contract are significantly cheap. On the other hand, going for equity-based fund-raise can be an expensive process.
Some concerns regarding convertible notes
There are two aspects to consider in terms of risks:
Not suitable for cash-strapped companies
If the company cannot raise a subsequent round of funding, then the debt may not convert to equity. In this case, the startup must repay the principal amount with accrued interest. This would prove difficult if the company is cash-strapped.
Not fixing proper terms and conditions
Secondly, if the convertible notes are uncapped, there is potential for the startup to relinquish more equity than they anticipated.
Hence, startups must fix the terms and conditions rationally to safeguard one’s interests.
Raising funding can be one of the most challenging journeys for any startup. Convertible notes present alternate options for startups.
However, startups must consider the pros and cons and make informed decisions. For instance, the terms and conditions of the agreement must align with the goals and financial capabilities of the startup.
This is where partnering with a specialist can help startups evaluate their options and make the right choices early on.
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