How Convertible Notes Work For Startups – The Complete Guide

How Convertible Notes Work For Startups - The Complete Guide

You need to source funding for your startup, but how will you achieve that?

One of the many options available to you is to make use of convertible notes, but they can be confusing if you’ve never heard of them before or if you don’t have much financial knowledge.

Why do startups use convertible notes?

Convertible notes are often preferred for startups because they have low legal costs and they’re not as complex as other financing types can be. 

However, that doesn’t mean that they’re always worth choosing.

With that in mind, here’s your ultimate guide on how to use convertible notes for startups and what you need to know about them so that they work for you instead of against you.

We’ll start by accurately defining convertible notes in a bit more detail.

If you’d like to see a graphical breakdown of the convertible notes, we got you covered:

Convertible Notes

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What, Exactly, Is A Convertible Note?

A convertible note can be defined as a short-term debt that becomes equity.

When we talk about seed financing, investors will lend money to a startup company as its first round of funding.

Instead of receiving the money with interest included, the investors will get shares of preferred stock, but it depends on the convertible note’s terms that have been specified.

Another way of describing a convertible note is to say that it works in a similar way to a loan that’s given to the company, but it comes with the difference of being converted into equity at a later stage.

The balance on the loan that’s outstanding will be converted into equity at a specific milestone, and this is usually at the valuation stage of a funding round.

Four Important Terms To Know About Convertible Notes

To better understand convertible notes and how they work, we need to look at four important terms that they’re usually associated with.

Discount Rate

This is the valuation discount that’s given to the holder of the convertible note.

It basically compensates them for the risk they are taking by investing in the startup company.

The discount stipulates a percentage reduction at which the note will be converted, as Funders Club puts it.

This enables investors to convert the amount of their loan and interest into shares of stock at a discounted price.

Valuation Cap

Valuation Handgiving

This term gets its name because it caps the price at which your convertible notes will become converted into equity.

So, valuation cap is basically the maximum valuation of the company when its debt is converted into equity.

It’s usually the case that a convertible note will have a discount rate and valuation cap, and will convert with the use of whichever one gives the investor a lower price for shares.

Interest Rate

Convertible notes will accumulate interest in the same way as a loan given to the company will do so, but the difference is that they won’t be paid in cash.

Maturity Date

This is the date when the convertible note needs to be repaid. This tends to be between 18 to 24 months after the investment has occurred.

An Example Of Convertible Notes And How They Work

Let’s look at an example (via Counsel For Creators) of how convertible notes work.

Imagine an investor wants to invest $10,000 into a startup with the use of a convertible note.

This note has a $4 million valuation cap, an interest rate of 4 percent, and a 15 percent conversion discount.

Seven months later, the startup manages to raise financing that’s valued at $5 million and has a price per share that’s 50 cents.

At this stage, the convertible note holder will get the discount of 15 percent that was agreed on earlier, which means he or she will pay 42 cents for every share.

Now, what about the valuation cap?

It was set at $4 million, so every share will have a value of 40 cents. Taking the 4 percent interest into account, the loan will have a value of $10,400.

The convertible note holder will use that $10,400 to buy shares in the company, and since these are 40 cents per share, this means that he or she will receive 26,000 shares in the startup.

Pros And Cons Of Convertible Notes

Illustration of Convertible Notes Pros And Cons

Pros

  • Legally, convertible notes are easier to document than other types of financing, which makes them less expensive. Convertible notes are also short agreements. They tend to be no more than five pages in length. That’s a whole lot shorter than the 40-odd pages that you’ll need when setting up stock agreements! Their shorter length results in convertible notes closing faster, which reduces the company’s legal fees.
  • You’ll receive funding you need for your startup right away. Convertible notes let investors give money to startups so that they can turn that debt into equity later. This means that as a startup, you’ll get the money you need without first having to define the equity value. It also means investors will be able to have a stake in the company from the beginning.
  • Linked to the above point, convertible notes benefit startup owners because they define the company’s value when there’s not much to base its valuation on since the company is still in its early stages – it might only be an idea at this point! This valuation will later be determined during Series A financing, a company’s first round of venture capital financing, as there will be more data available.
  • Convertible notes give you more flexibility. This is because they can close at any time.
  • They have long maturity dates. Convertible notes usually have a maturity date of between 12 and 18 months, but this can be extended to 24 months. If you do so, you can have much more time at your disposal within which to procure the capital you need. Bear in mind, if the convertible notes can’t be turned into equity, they will need to be repaid.

Cons

  • While convertible notes can be useful for startups and investors alike, they can end up being costly for startups – that’s why it’s of the utmost importance to know the terms of the convertible notes from the beginning so that they don’t backfire.
  • Some investors might think that investing in a startup can be tricky with the use of convertible notes because these notes make it harder for them to figure out if the terms are fair or not. There are so many unknown factors, especially if the company in which they’re investing has just been set up. This can make convertible notes feel like they offer less security when compared to other investments.
  • Convertible notes don’t provide long-term capital gains treatment until after they’ve been converted, which can be a long time.

Differences Between Convertible Notes And Preferred Stocks

Paper With Preffered Stock

Is using convertible notes right for your startup?

Let’s look at some important differences between convertible notes and preferred stocks.

What’s A Preferred Stock?

A preferred stock is like a common stock, but it also has traits that are common with debt instruments.

A convertible note, on the other hand, gives you the chance to change the loan of money into shares.

We’ve defined and explained convertible stocks, so let’s look at preferred stocks in better detail.

  • Just like common stocks, preferred stocks pay dividends but have a higher rank in case the company is liquidated.
  • As a preferred stockholder, people will get dividend payments before common shareholders in the event of liquidation.
  • These stocks have long maturity dates that can be up to 50 years or they might not even have a maturity date.

An important advantage of preferred stock for investors and entrepreneurs concerns the company’s valuation.

With convertible notes, an investor is motivated to want the company’s valuation in Series A financing to be low so that they’ll have more ownership in the company.

However, with preferred stock, when an investor conducts an equity investment, their motivations will be more aligned with the startup’s entrepreneur, as Startup Blog reports, which means they’ll both work to make the company as valuable as it can possibly be.

Are Convertible Notes Better?

  • When convertible notes are better – Convertible notes are a good idea for you if your company can achieve a high valuation and you think it will achieve this at a fast rate – the maturity date of the convertible note could increase some pressure in this regard.
  • When preferred stock is better – Preferred stock, on the other hand, is a better idea for company owners who can negotiate a substantial valuation during their seed round and can also take on the legal costs of this transaction.

Other times you should use convertible notes are when you’re taking on small initial seed rounds or you’re using them as supplemental bridges between priced rounds, as Halo Business Angel Network (HBAN) reports.

The reason is because they’re cheaper, less legally-intensive, and simpler to negotiate.

So, if you’re just starting out with your company, you could close investors one at a time on a rolling basis and you could do smaller rounds without costs of your transactions becoming too hefty as a percentage of the round, HBAN goes on to explain.

Are Convertible Notes Appealing To Investors?

Handgiving Money

Sometimes convertible notes can be off-putting to investors.

Earlier, we touched on how these notes can be unpredictable, which can make investors wary of them.

While their advantages benefit startup entrepreneurs, they’re not always that great for investors. This is why convertible notes are sometimes avoided by them.

There are other reasons why investors might want to choose stocks over convertible notes, which you should know about as a startup owner.

  • Investors don’t get any protection. When using convertible notes, investors don’t have access to protections such as protective provisions, registration rights, and so on. While entrepreneurs can tweak agreements in order to give noteholders more protection, this kind of goes against the whole point of using convertible notes: their simplicity and ease of use. Once you make them more complicated, the whole process becomes difficult and cumbersome.
  • Investors might not agree on price. Since you don’t get the price of the stock at the time you commit, as an investor you could lose out – if the price on a future round is high, the startup owner will win and less stock will be given to the convertible note holder. On the other hand, if the price is low, investors will get more stock than what they originally invested, but this puts the startup owner at a bit of a disadvantage. Of course, this issue can be dealt with effectively with the use of a price cap. In other words, there’ll be a limit on the maximum price at which note holders will convert.

What About SAFE?

SAFE stands for Simple Agreement for Future Equity.

A SAFE agreement gets signed during investment rounds, usually during seed or pre-seed stages.

It serves to protect both the entrepreneur’s and investor’s rights with clear rules for how equities should be treated during Series A funding.

As a startup owner, you sign this agreement and promise the investor a chunk of shares during the next stage of funding in order to receive capital immediately.

What SAFE and convertible notes have in common is a conversion into equity at a future time.

That said, there are some important differences between convertible notes and SAFE notes.

  • For starters, a SAFE note is not a debt, while a convertible note is considered to be a debt.
  • SAFE notes don’t have an interest rate or maturity rate. They also don’t always have discounts or valuation caps.
  • SAFE notes are shorter than convertible notes. The longer length of convertible notes can pose problems for investors and entrepreneurs because they can cause misunderstandings to occur which complicate the entire process.

That doesn’t mean that convertible notes don’t have advantages over SAFE notes, however. Here’s a rundown of some of the most important ones.

  • You get more control when you use convertible notes. You can add more rules and stipulations to your convertible note agreement so that you get the best deal for yourself and your company.
  • You can actually benefit from how convertible notes are a bit more complicated than SAFE notes. This is because using them with your investors can help you to appear to be a more experienced entrepreneur.
  • With convertible notes, you can set stipulations to the note’s maturity date. This could include paying the loan back with interest. Although the maturity date of your convertible note could make you think that you’re locked into a deadline, you do have many options as to how you convert the note. SAFE notes, on the other hand, don’t have maturity dates. This means that investors could end up waiting for a really long time for maturity even when the company has started to make a profit. This makes them riskier for investors.
  • You can make use of dilution. Convertible notes are said to dilute each other. So, if you have multiple investors signed up to a convertible note agreement, the smaller their stake will be at the time of conversion, as investor and entrepreneur Alejandro Cremades explains. This means that the company owner will get a larger investment for a smaller amount in their company. On the other hand, when you sign a SAFE note with your investor, this doesn’t dilute the original note. This means that the noteholder will receive the same amount of your company when you convert.

Related Questions

Businessman Shaking Hands

What is the Most Favored Nation Clause in convertible notes?

This is an unusual term applicable to convertible notes that allows the note holder to choose to gain any more favourable terms offered to subsequent investors after the investor’s original investment and before the next equity round.

How are convertible notes taxed?

Investors need to pay tax on these notes – and that’s the case even though they didn’t receive the interest in cash.

If someone invests $100,0000 in an 8% convertible note, they must pay over $2,000 in cash to the IRS on that income, as Rockie’s Venture Club explains.

Conclusion

Convertible notes are a simple and often effective way of gaining financing for your startup, but there are important things you should know about them.

In this article, we’ve outlined convertible note pros and cons, and compared them to preferred stock as well as SAFE notes.

It’s clear to see that convertible notes have many advantages, but it’s always important to ensure that they are clearly defined so as to appeal to both yourself as the startup owner and your investors.

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