Finance for Entrepreneurs - What are Convertible Notes?

When we are talking about how simplified the financing process has become, it is not unusual to mention the expression “convertible note”. Pointed out as an increasing trend among the entrepreneurial community, its value and suitability are not as certain to reach consensus. Let’s take a look at the most important features in a convertible note.

Convertible note? What is it?

A Convertible Note is a promissory note that may convert into equity in the future at some predefined terms. An investor loans money and instead of getting it back plus interest, he has a promise of stock on the next round of capital (Series A) according to the terms of the agreement. This stock can be provided at a discounted rate, to compensate the investor for the higher risk taken.

Advantages

There are some main advantages frequently highlighted: no valuation, simplicity, speed, cost, lack of control from investors and flexibility.

Valuation is not always a piece of cake. Postpone it will give time to collect more data and establish a better (more accurate) analysis.

Issuing a convertible note also takes less time and costs less than a traditional Series A financing round: there are fewer legal fees and conditions to negotiate.

Usually there are not control rights for the investors in a convertible note, unlike with the preferred stock holders (you can read more about control rights on the previous article about term sheets).

The last main advantage of a convertible note is its flexibility. As Paul Graham concludes: “The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations and notes are cheap and easy to do. So you can do high-resolution fundraising: if you wanted you could have a separate note with a different cap for each investor.”

Disadvantages/Concerns

A convertible note is mainly a loan, not an investment. If you don’t get a series A financing round until the maturity date, you are left with a loan to pay plus interest. That’s why many convertible notes have an automatic conversion option: it establishes how the conversion into stock will happen in case of not having a series A and helps avoiding bankruptcy.

With standard convertible notes, the early investors receive the same number of shares, no matter what the value of the company is. Early investors may be penalized even though they took higher risks. Investors often want a conversion value cap in order to solve that unbalance. Caps set a maximum price an investor will pay for shares, but they don’t set a minimum, forcing the founders to take all the risk when it comes to price. For instance, if the founder and the investor agree that the company worth at max 1 million and it ends up valuing 2 million, the investor gets 50% discount. But if your company ends up worth half of the price you thought when you raise the series A, your convertible note holder still gets the same amount of shares, meaning he has twice as many shares as he would have if you opted for a traditional seed valuation.

Structure

Principal: the amount the company is “borrowing” from the investors.

Interest: the cost of borrowing money, typically expressed as an annual percentage rate.

Risk Premium: sometimes there is a compensation, since the early investor has higher risks than the following ones. It can happen using a discount (in the price of shares in following financing rounds) or issuing warrants.

Maturity: the date in which the investor can look for repayment of the note.

Prepayment: conditions in which the entrepreneur pre-pays the note, ending the legal bond. Usually there has to be approval from the majority of the convertible notes’ holders.

Automatic Conversion: how the notes are converted into common or preferred stock, in case of a Series A round of capital. Can also include an option referred to the case of not having a next financing round until the maturity date.

Sale of the company: indicates what happens in the case of an acquisition prior to conversion. Normally it says what price the investor can convert the note at.

Final notes

Finding out how to raise your first money when you start a company is definitely a challenge. Even though there is a lot of information all over the place, ultimately you will have to decide what suits your company the best. Surround yourself with experienced people with different backgrounds – they are a gold mine, and can really help you face the problems.