Investing Through Convertible Notes

We are in the golden age of seed funding. The seed financing game is booming, capital funds, angel groups, incubators, and “friends and family” are all trying to put their feet in it and investing early in startups in an attempt to land the next Facebook. This turned out to be very crucial for the founders, the pendulum has swung dramatically in the founders’ favor and the issuance of convertible debt for seed financing has never been more prolific.

What is a convertible debt?

When a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date is called a convertible debt.

The convertible debt is classified into 4 types:

  1. Convertible Notes
  2. Simple Agreements for Future Equity (SAFE)
  3. Keep It Simple Security (KISS)
  4. Simple Agreements for Future Tokens (SAFT)

What is a convertible note?

A short-term debt that converts into equity is known as a convertible note, typically in conjunction with a future financing round. In effect, the capitalist would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor would receive equity in the company.

Convertible Note Terms:

There are a few key parameters that must be kept in mind while evaluating a convertible note:

  1. Discount Rate - This represents the valuation discount you receive relative to investors in the subsequent financing round, which compensates you for the additional risk you bore by investing earlier.
  1. Valuation Cap - The valuation cap is an additional reward for bearing the risk earlier on. The main purpose of this is that it caps the price at which the notes will convert into equity and provides holders with equity.
  1. Interest Rate - The notes will accrue interest from the day they are issued until they are converted into shares or are repaid. Most of the time the interest rate will be set to zero or the lowest interest rate legally required.
  1. Maturity Date - This denotes the date on which the note is due when the company needs to repay it.

What makes convertible notes so popular?

The investors and founders of the company are able to postpone the discussion of the startup’s valuation, which is an estimation of the company’s worth. These agreements can also be drawn up at a much faster rate and at a cheaper cost when compared to standard equity deals. The use of convertible notes makes the finance process much more straightforward.

Pros and Cons of Convertible Note Financing:

The benefits of using convertible note financing include:

  1. This form of financing is widely used and accepted by financiers.
  2. Easy to negotiate.
  3. These transactions cost less than stock offerings.
  4. The legal fees for a convertible note transaction is less than venture stock deals.

The cons of convertible note financing include:

  1. If you want to bring in a large number of angel investors, it can be difficult to keep track of all the convertible notes that you need to create.
  2. If the company doesn’t reach the Series A round of financing, you will need to pay back the entirety of the investment once the loan has reached maturity.
  3. Investors are able to obtain shares in your company that are 15-25 percent cheaper than what they would cost aftermarket valuation.

Convertible notes offer a very rapid way of generating cash, often exactly what your startup may need. However, you need to additionally take into account some consequences of using convertible debt as a means of financing. 

The debt is a debt and must be paid hence convertible debt may be damaging to the company if it does not succeed-. If the company is struggling to raise cash and the maturity date is reached, the debt must be paid – potentially forcing a liquidity event if the firm is not cash-buoyant enough. As an entrepreneur one should understand the risks and rewards with their convenience, hence make their decisions.

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