What is a Convertible Note?

Convertible notes are short-term debt instruments that convert into equity under specific conditions. They function as short-term loans issued by startups to investors. Initially, investors act as creditors, providing capital to the company. However, a crucial feature differentiates them from traditional loans: the conversion clause.

Upon fulfilling predetermined milestones, typically a subsequent equity financing round, the note "converts" into equity, transforming investors into shareholders.

This makes convertible notes an attractive option for dynamic early-stage ventures, offering flexibility and potential upside for both parties.

📍 A great resource for in-depth reference

Slidebean founder explains about equity and convertible notes, and how they work together in very depth. Check it out for a more in-depth guide on how convertible notes works.

Advantages of Convertible notes

Convertible notes offer faster fundraising, strategic valuation advantages, and incentives for early investors.

1. Simper equity financing rounds

Compared to the often lengthy and complex equity financing rounds, convertible notes offer a swifter and more streamlined fundraising process. With less paperwork and legal hurdles, startups can secure capital more efficiently, allowing them to capitalize on fleeting opportunities and maintain momentum.

2. Discounted share price for early investors

Early-stage startups often lack a definitive valuation. Convertible notes alleviate this pressure by postponing formal valuation until a future funding round.

This strategy can be advantageous if the company experiences significant growth, as investors convert at a pre-determined discount, effectively securing shares at a lower price.

3. Higher upside for investors, resulting in more investment interests

To compensate for the inherent risk of investing in unproven ventures, convertible notes typically include investor-friendly terms. Conversion discounts and valuation caps offer the potential for significant equity upside, attracting investors willing to take a chance on promising startups.

However, it's crucial to carefully balance these advantages with the potential drawbacks.

Disadvantages of Convertible notes

Convertible notes can lead to dilution, control issues, and financial strain. While conversion discounts incentivize investors, they come at the cost of potential dilution for founders.

1. More dilution of shares and control in the future

When a high-performing company attracts funding at a significantly higher valuation, the discounted conversion translates to a larger number of shares issued to noteholders, diluting the founders' ownership stake. In exchange for funding, founders may need to concede certain control rights during the note period.

These concessions, often outlined in the note terms, can impact decision-making processes and strategic direction. Finding a balance between securing funding and maintaining control is crucial for founders.

2. Adds the pressure of interest amounts to the deal

Unlike traditional equity, convertible notes accrue interest, adding to the financial pressure on young startups. If conversion triggers are not met within the stipulated timeframe, the company faces the obligation to repay the principal amount plus accrued interest.

This can strain cash flow and limit resources available for core operations. Carefully assessing these potential drawbacks and negotiating terms that align with the company's goals is essential before issuing convertible notes.

Convertible Note vs. Safe Note

Safe notes offer similar benefits but with an added layer of downside protection for investors.

Conversion Triggers

Convertible notes: Convert upon specific events like raising a future funding round at a predetermined minimum amount.

Safe notes: Convert during the next priced equity round, regardless of the amount raised. Some safe notes offer "pay-to-play" provisions, allowing investors to convert if they participate in the next round.

Downside Protection

Convertible notes: Typically don't offer downside protection for investors. If the company fails to meet conversion triggers, the note simply matures, requiring repayment of principal and accrued interest.

Safe notes: Offer various levels of downside protection. Many guarantee a fixed interest rate regardless of conversion, and some even offer principal repayment upon maturity if certain conditions are not met.

Interest

Convertible notes: Typically accrue interest, adding to the financial burden on the company if not converted promptly.

Safe notes: May or may not accrue interest, depending on the specific terms. Some safe notes with principal protection features often come with higher interest rates compared to standard convertible notes.

Valuation

Convertible notes: Often include conversion discounts and valuation caps, offering investors a lower entry price and limiting potential dilution for founders if the company experiences rapid growth.

Safe notes: Rarely utilize discounts or caps, as the conversion price is typically determined by the next priced round valuation. This can be less favorable for investors if the company underperforms in subsequent rounds.

Dilution

Convertible notes: Can lead to significant dilution for founders, especially with large discounts and if the company experiences high-growth valuations in future rounds.

Safe notes: Generally offer less dilution risk for founders as the conversion price is not discounted and reflects the company's performance at the time of the next round.

Is a convertible note an asset or liability?

Convertible notes are classified as liabilities for the company and assets for investors.

From the company's perspective, a convertible note remains a liability until it converts, as it represents an outstanding debt obligation. This classification impacts financial reporting and accounting practices, requiring the company to record the note's principal amount and accrued interest on its balance sheet.

For investors, however, the note represents an asset with the potential for significant equity upside, depending on the company's performance and future financing rounds. The value of this asset fluctuates based on the company's progress and the terms of the note, making it essential for investors to carefully track and monitor their convertible note holdings.

Do convertible notes need to be paid back?

Although technically repayable, repayment of convertible notes is uncommon in practice.

Technically, convertible notes carry a maturity date, requiring repayment of the principal amount plus accrued interest if conversion doesn't occur by that deadline. However, in practice, repayment is uncommon.

Investors typically prioritize equity conversion, seeking the potential for higher returns compared to fixed interest payments. Additionally, early-stage startups often lack the financial resources to repay large sums at the maturity date, making conversion the more viable option for both parties.

Nonetheless, understanding the repayment clause and its implications is crucial for both founders and investors, as it can impact financial planning and decision-making.

Is a convertible note risky?

Convertible notes involve inherent risk for both investors and founders.

Investors face the uncertainty of company performance and potential dilution upon conversion. If the company fails to meet its milestones or underperforms, investors may receive a lower return than anticipated or even lose their entire investment.

For founders, the risk lies in losing control and facing significant ownership dilution, especially if the company experiences explosive growth.

Additionally, the debt burden associated with accrued interest can add financial pressure to young startups. Careful due diligence, negotiation of terms, and clear communication are essential for mitigating these risks and ensuring a mutually beneficial outcome for both founders and investors.

Convertible notes example

An example demonstrates the potential benefits and drawbacks of convertible notes.

Imagine an investor provides $100,000 through a convertible note with a 20% discount and a $5 million valuation cap. If the company raises $2 million in a future round at a $10 million valuation, the investor converts their note into $125,000 worth of shares (discounted from $150,000 due to the cap).

This example highlights the potential benefits for investors, who gain equity at a lower price and potentially enjoy significant upside if the company thrives.

However, it also underscores the dilution impact on founders' ownership, as the investor receives a larger number of shares due to the discount. Carefully considering the specific terms and potential outcomes is crucial before issuing or accepting convertible notes.

Final thoughts on Convertible notes

While convertible notes offer a swift and flexible path to funding for early-stage startups, they're not without their complexities.

This unique debt-equity blend allows for speedy fundraising and postpones valuation, but founders must be wary of potential dilution, control limitations, and financial strain. Carefully consider your company's needs, risk tolerance, and investor alignment before diving in.

Remember, convertible notes are a valuable tool, but not a permanent solution. As your company matures, explore alternative financing options that align with your evolving journey towards success.