We feel sorry for the convertible note. It doesn't have a
sexy ring like crowd-sourced equity funding, and for some reason
Australians just don't love them like the Yanks. But notes have
a place (especially in start-up financing) and so, before
structuring your next round of funding with a VC or angel investor,
arm yourself with our convertible note 1-2-3:
What are convertible notes?
Why are the Yanks so hot for them?
What key pricing terms are normally negotiated?
What is a convertible note?
It is a loan that converts to equity at some later date or is
paid off. It is a common form of seed stage financing, which is
popular and prolific in the United States, but remains
comparatively rare in Australia.
Why do the Yanks love them so much?
The main argument is that it is an easier transaction than
equity financing. The company and the investor avoid having to
value the shares, and as the investor is not getting control rights
(as you normally would as a shareholder) the paperwork involved
(and therefore legal fees) is far less.
What are the normal pricing terms?
The price at which the notes convert is usually the most
important term. Convertible notes normally convert at the lower of
a discount or a cap.
The "discount" rewards the investor, paying them not
only interest on the loan, but also giving them equity (on
conversion) at a discount to whatever the next round of investors
pay. For example, a 20% discount means that, if investors pay $1
per share in the next round, then the note will convert into the
same shares at $0.80 per share.
The "valuation cap" is the other key (investor
favourable) term. The cap is a ceiling on the value of the company.
Just like a discount, it allows the investor to convert their loan,
plus interest, at a lower price than what the next round of
investors pay. Without a cap an investor just gets a fixed discount
when the note converts, which sounds ok, but if the value of the
company goes through the roof investors end up with an ever
diminishing share of the company.
Not really all that complicated and, like hipsters, old words
can always have new meaning.
We do not disclaim anything about this article. We're
quite proud of it really.
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