Convertible Notes

Startup companies often need to raise capital from outside investors to continue growing, and to get to the point where they can self-sustain. A typical startup will go through a series of stages in raising funds for its growth. The company will initially be funded by its founders. Next, the company will look to outside sources that already have a relationship with the company and its founders. These are often the banks where the startup has accounts, along with friends and family of the founders. Last, the company will look to professional investors. In short, the funding stages look something like this:

1. Initial founders contribute their own money

2. Founders may get a bank loan or line of credit

3. Founders’ friends and family may lend money or invest

4. Founders turn to professional investors (angel investors or venture capital firms)

As part of the fourth stage — again, if a startup gets there at all — a common form of initial investment from an outside investor is a convertible note. Convertible notes are simply loans made by an outside investor (typically an angel investor) that later convert into equity (i.e., ownership) in the company when the company successfully raises its next round of capital. Most often, the next round that will follow convertible debt is preferred stock, which is then raised in sequential rounds, often each referred to as a “series” (for example, Series A, then Series B, then Series C, and so on).

Why Would A Company Want to Raise Money Through Convertible Notes?

Convertible notes allow startups to relatively quickly raise money from sophisticated outside investors without having to agree upon a valuation of the company at the time of the investment. Startups are difficult to value since they are young companies without much operating history, have plenty of room for growth, and they may have not yet proved out their model or learned the extent of the market they are trying to capture.

An infusion of capital from an outside investor in the form of a loan (the convertible note) allows the company to continue growing so that it can get to the next round of investment (the preferred stock), at which point the company will, with any luck, be in a better position to be properly valued.

So, the flexibility of not having to value the company, while still receiving an investment, is the biggest advantage of raising capital through a convertible note.

What Are Some of the Specific Terms?

Most importantly, the investor will ask for a discount on the pricing of the next round of investment, which will be the Series A preferred stock. This means that, when the company raises money in its Series A preferred round, the debt will convert to Series A preferred stock at a discount on the price. In other words, the investor who gave money to the company under the convertible note will be rewarded for his or her investment before a full blown Series A financing round is closed. The discount is often somewhere between 10% – 30% on the price of the Series A round.

As an example, if an investor were to give a company $100,000 under a convertible debt financing with a 20% discount on the next round, then, if the company later raised a Series A preferred stock round of $500,000 at $1 per share, the Series A investors would receive 500,000 Series A preferred shares, and the convertible debt investor would receive 125,000 Series A preferred shares ($100,000 at $.80 per share).

Another important term of a convertible debt financing is a valuation cap. This sets a ceiling on the price that the convertible debt investor will agree to pay as part of the Series A round. A valuation cap assures the investor that his or her equity won’t convert at a price higher than what he or she would have paid if he or she had simply purchased equity in the company in the first place. In that sense, it’s a protective mechanism for the convertible debt investor. On the other hand, it can hinder a company looking to raise money in a Series A round since the investors during that round won’t want to allow the convertible debt investor to pay a lower price than they believe is fair.

Those are some of the most important terms of a convertible note financing, and, with all of that said, it’s important not to get too worried about, or caught up in, all of the specifics of the deal, at least at the outset. As with any capital raise, your company and its founders first should make sure everyone is comfortable with the investor on the other side of the deal. Trust is critical in taking money from outside investors. Unwinding a bad deal can be far, far more painful than not getting money right away, especially when a company is young and doesn’t have much leverage against investors.