Convertible notes are a common form of startup funding. If you are an early-stage startup in the tech space trying to raise capital, ELR12 will break down convertible notes for you.
How do convertible notes work?
A convertible note is a type of debt financing that a startup can use to raise money. It is an agreement between the company and the investor to convert the note into equity at a future date. The company will receive cash now. And in return, they will give the investor shares of stock at a future date.
The document itself is an investment contract. In simple words, it’s is an IOU (acronym for I owe you) which states the amount of money invested, the terms of repayment and the conversion rate.
The convertible note is a loan or an investment. The investor receives interest on the loan and might get their money back if the company fails. The most common use case is when an investor invests in a company and gets paid back interest, like any other loan but also has the option to convert their investment into equity if the company goes public or gets bought by another company.
The holder of the note can elect to convert their debt into equity in one of two ways:
- When the company has met certain milestones, such as receiving an investment from an outside party or completing a round of financing.
- When the company reaches a predetermined valuation (usually set by the holder).
Why are convertible notes so popular?
A convertible note is a hybrid instrument that combines aspects of both debt and equity financing. The use of convertible notes has been steadily increasing in recent years. Partly because they are an attractive option for startups that have difficulty obtaining funding from banks or venture capital firms.
The interest rates on these types of notes are usually lower than those on traditional loans. They also don’t require collateral or personal guarantees from the founders or investors. This makes them appealing for both investors and founders alike because they allow startups to take risks without risking their personal safety net.
This allows investors to get in at an early stage and provides companies with the capital they need to grow. Convertible notes are popular because they allow both parties – investors and companies – to have more flexibility than they might otherwise.
Convertible notes make it easier for investors to exit their investment. They can convert their debt into equity, and this will allow them to sell their shares at a higher price.
This type of investment is very common for startups with an established product and a proven market.
What is the difference between a convertible note and an equity investment?
Equity investments and convertible notes are the two most common types of startup funding options. It is important to know the difference between these two types of investments because they have different implications for investors and startups alike.
An equity investment is an investment in a company that entitles the investor to a share of the company’s profits and assets (or losses). On the other hand, a convertible note is a type of convertible debt that becomes equity at some point in the future.
A convertible note is a type of debt financing that is typically more expensive than equity financing. The company gets cash up front and has to pay back with interest. Whereas with equity financing they share in the profits with no need to pay back.
Equity investments are more risky than convertible notes because if the company goes bankrupt, you lose all your money. Convertible notes are less risky because you get paid interest on them and they don’t turn into equity unless you decide you want to convert them.
A convertible note is more of a short-term investment, where the investor receives interest but has no voting rights or control over the use of the money. While in an equity investment, the investor receives voting rights and shares in the company’s profits.
A convertible note can be converted into an equity of the company, but not vice versa.
What are some potential drawbacks of raising money with a convertible note?
A convertible note is a note with an agreed-upon conversion price. If the company is successful, the investor will get their money back and make a profit on their investment. But what are there any cons that need to be considered before funding a startup through convertible notes?
Company POV
- Convertible notes are destructive when used carelessly. Having too many notes or poorly structured notes outstanding can put your company and later negotiations at risk.
- It can dilute ownership for existing shareholders. The company will be losing some equity, since they are giving up part of their company in exchange for cash. This can be problematic if they want to sell their shares in the future.
- Investors can gain more control over the company once they decide to convert their convertible notes into shares. Meaning they can force changes in management or business strategy, which could lead to some issues later on if there is a disagreement about how the company should move forward or what direction they should take.
- The company will have less room to grow. They will have to pay back the debt before they can raise more money from investors.
- Convertible notes are usually more expensive than traditional equity rounds, which means that startups have less capital to grow their company.
Investors POV
- Convertible notes don’t provide any protection for investors if things go wrong and the startup fails. Investors will not be able to sell their shares or get any dividends until they convert their note into equity. Implying that startups could go bankrupt without giving them anything back in return.
- The conversion price is usually lower than the current market price because it’s set at the time of issuance.
- There is no clear timeline on when investors will be able to get their money back.
- They’re not getting any equity in the company as long as they haven’t converted their debt into shares. This can be problematic if they want to have some control over the company’s direction or any say in future decisions.
- A convertible note can be difficult to convert into shares when they mature. Investors may not get their desired return on investment if they don’t sell their shares before maturity. Or if they do not get enough capital from the sale to cover what they invested in the first place.
Finally, the conversion process can be difficult and time-consuming for both parties if it’s not handled properly.
Conclusion
As the world of startups continues to grow, so does the number of investors looking to get in on the ground floor. Convertible notes are a relatively new form of startup funding that offer a lot of potential for both investors and startups.
In the past, startups were often funded by venture capitalists or angel investors who would invest a large amount of money in return for equity in the company. This is not possible anymore as companies are forced to focus on developing their product and generating revenue instead of spending time trying to sell their shares to investors.
To summarize, convertible notes are an excellent way for startups and investors alike to start what could be the next big thing without risking too much money upfront. Which is why we believe that the future of startup funding looks bright with this type of financing method!