Convertible notes, also known as “convertible loan notes” or “CLNs,” have gained significant traction in the startup financing landscape, especially among seed-stage companies.
What is a Convertible Note?
A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. In essence, the investor loans money to a startup and instead of getting a return in the form of principal plus interest, the investor would receive equity in the company.
What Is a Senior Convertible Note?
A senior convertible note is a debt security that gives the holder the right to convert the note into shares of the issuer’s common stock. Being “senior” means it takes precedence over other debts in case of a company’s liquidation.
Is a Convertible Note Debt or Equity?
A convertible note is initially a debt instrument, but it is designed to convert into equity. The conversion typically happens during a future financing round.
How Does a Convertible Note Work?
When an investor invests through a convertible note, they are technically lending money to the startup. The note includes terms such as the interest rate, maturity date, and conversion terms. At a predetermined point, usually at a qualified financing event, the loan will convert into equity.
What is a “Priced Round” and is that Different?
A “priced round” is when investors and the company agree on the value of the company, and thus the price per share of the investment. This is different from a convertible note, which doesn’t require setting a valuation for the company at the time of the initial investment.
When Convertible Debt Makes Sense
Convertible debt can make sense when a startup needs quick funding, and when the company and investors want to postpone setting a valuation until a later time, typically when more information is available to make a more accurate valuation.
Advantages of a Convertible Note in Venture Capital
Convertible notes are advantageous because they are quick and cost-effective. They allow startups to avoid immediate valuation, and they offer investors potential upside when the notes convert into equity.
Disadvantages of a Convertible Note in Venture Capital
The main disadvantage of a convertible note is the risk for investors that the note may not convert into equity if the startup fails. For startups, the disadvantage is the potential for high dilution if the company’s valuation at the next round is lower than expected.
Convertible Note Terms
Convertible note terms include the principal amount, interest rate, maturity date, conversion terms, and sometimes a valuation cap and discount rate.
What is a Cap in a Convertible Note?
A cap in a convertible note is a maximum company valuation at which the note can convert into equity. It protects investors by providing more equity if the company’s valuation increases significantly.
Convertible Note Example
For example, if an investor provides $100,000 through a convertible note with a $1 million cap, and the startup’s next round values the company at $2 million, the investor’s note will convert as if the company was valued at $1 million, providing them with more shares.
SAFEs vs. Convertible Notes
SAFEs (Simple Agreement for Future Equity) are similar to convertible notes but do not include interest or a maturity date. They were designed to be simpler and more startup-friendly than convertible notes.
Can a Convertible Note Be Paid Back?
Typically, convertible notes are designed to convert into equity rather than being paid back. However, if the note reaches its maturity date without a conversion event, the startup may have to repay the note.
Why Do Startups Use Convertible Notes?
Startups use convertible notes to raise capital quickly without having to negotiate and set a company valuation. They are a flexible and efficient way to secure early-stage financing.