Convertible Note

A convertible note is a type of loan that startups use to raise money from investors. It's called "convertible" because, instead of paying back the loan with cash, the startup agrees to convert the loan into shares of the company at a later date. This usually happens when the startup raises more money during a future funding round.

Convertible notes are a great tool for startups needing early-stage funding without the hassle of immediate valuation and complex equity agreements. They offer investors a chance to get in early with some protections and the potential for future equity. Simple, flexible, and efficient, convertible notes help startups and investors navigate the early stages of funding and growth.

• Loan Money for Shares: Investors lend money to startups with the promise of getting shares later. The “convert” part of convertible notes.
• Future Conversion: Converts into equity during a future funding round. Because of this, convertible notes are commonly used in the early stages of a startup by giving some breathing room and basing value off potential success.
• Interest and Discount: Often includes interest and a discount on future shares to reward investors for getting involved early when risk is higher. Other early investment strategies, like SAFEs, have this in common.
• Investor Security: Provides a safer investment option for early backers, mitigating risk as much as is manageable.

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How a Convertible Note Works

1. Investment: An investor gives money to a startup as a loan.
2. Interest: The loan usually accrues interest over time, unlike a Simple Agreement for Future Equity (SAFE).
3. Future Round: The loan converts into shares when the startup raises more money.
4. Discount Rate: The investor gets a discount on the price per share during the conversion.
5. Valuation Cap: Sometimes, a cap (or ceiling) sets the maximum price at which the loan will then convert into shares.

Key Terms in a Convertible Note

Principal Amount: The initial amount of money the investor loans to the startup.

Interest Rate: The rate at which the loan accrues interest. Rates usually reflect current interest rates from the Federal Government.

Maturity Date: The date when the loan must be repaid or converted into shares.

Discount Rate: The percentage discount the investor gets on the share price when the loan converts. Due to the higher risk, investors get a better deal by getting in early with a convertible note.

Valuation Cap: The maximum valuation for when the loan converts into shares, protecting the investor if the startup's valuation skyrockets. Valuation is the projected worth of a company and its assets.

Advantages of Convertible Notes

• Speed: Quicker to arrange compared to traditional equity financing. In many industries, first-to-market is a crucial indicator of success.
• Flexibility: Terms can be customized to fit both the startup and investor needs.
• Investor Protection: Interest and discount rates provide some security to investors, even though early investments often mean higher risk.
• No Immediate Valuation Needed: Defers the need to set a company valuation, simplifying early-stage funding. However, valuation can be subjective, presenting future hurdles in validating the amount with outside investors.

Disadvantages of Convertible Notes

• Uncertainty for Investors: Investors only know the exact percentage of ownership once the note converts.
• Potential for High Dilution: Future funding rounds can dilute investors' shares. Some industries and products will inevitably raise large amounts of capital and dilute investors accordingly (food and beverage, for example).
• Repayment Risk: If the startup doesn't raise more money, repaying the loan can strain its finances, unintentionally resulting in other issues.

Common Uses for Convertible Notes

• Seed Funding: Startups use convertible notes to raise initial capital quickly.
• Bridge Financing: Helps startups get through until the next major funding round.
• Accelerator Programs: Many startup accelerators invest in their cohorts using convertible notes.

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Example Scenario

Imagine you invest $50,000 in a startup via a convertible note. The note has a 6% interest rate, a 20% discount rate, and a $5 million valuation cap.

1. Investment: You lend $50,000 to the startup.
2. Accrual: The loan accrues 6% interest over a year, making it worth $53,000.
3. Future Round: A year later, the startup raises a Series A round at a valuation of $10 million.
4. Conversion: Because of the 20% discount, your loan converts at an $8 million valuation (20% off the $10 million valuation).

Shares: Your $53,000 converts into shares at this discounted valuation.

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