Most entrepreneurs are usually faced with the issue of funding at the early stages of building their startups. They seek ways to resolve this without running into debt and potentially losing their companies. One such option available to resolve this is the issuance of a convertible note. Convertible notes have become popular in the world of startup financing, particularly in seed-stage companies. However, it is important to understand whether or not it is the best option for your startup. In doing this, we shall provide an overview of a convertible note and its components.
Convertible notes, also known as convertible debt, are an investment option used by early-stage investors to provide funds to a startup while delaying the valuation of said startup until a later date. They are originally structured as debt investments but with a provision that allows the investor to convert the principal plus accrued interest into an equity investment when a specific trigger event happens. They are loans made to startups at the very early stages that are intended to be short-term debt that will convert (with interest accrued) into equity based on the next qualified financing round (often from Venture Capitalists and Angel Investors). However, unlike bank loans, these types of loans are not necessarily paid back with money. Instead, the loan will be converted into equity (stock) in the company. Essentially, they are a mashup of debt financing and equity financing.
An example of how this works is; Mr. X wants to invest N1,000,000 into Mr. Y's startup. Both parties decide to draft a convertible note for N1,000,000 with an interest rate of 2% for a period of one year. At this stage, no valuation has been done on the startup, so Mr. X's investment is merely a loan, not equity. The parties may decide to convert the loan to an investment in the next round of financing. At the next funding round, Mr. Y's startup will be valued at N10,000,000. The convertible note will allow Mr. X to convert his invested capital plus the accrued interests into equity in Mr. Y's company. Convertible Notes have become the standard method of early-stage fundraising because convertible note alternatives have sped up the ability of angel investors to start investing earlier. Another reason for its attractiveness to investors is that it is faster and cheaper to execute and is also well-understood by both angel investors and venture capitalists.
Furthermore, while the convertible note is in place, the invested capital accrues interest just like a regular loan. This interest which builds up over time, adds value to the capital. Although, as mentioned earlier, this interest may not be paid in cash, unlike the regular loan. Convertible notes also carry a maturity date at which the notes are due and payable to the investors. At this point, the invested capital and the interest are usually converted to equity. However, the investor may decide to recoup his investment instead of converting it to equity at maturity. It all depends on how the parties decide to structure the transaction. The main reason for the use of a convertible note is that it will convert into equity at some point in the future. Also, if a round of financing does not occur before the maturity date, some convertible notes include a provision in which the notes automatically convert to equity at a set valuation on the maturity date.
This type of funding was pioneered to allow early-stage startups to obtain quick loans from private investors in exchange for a promise to repay those investors with equity at a later time when the startup's equity could be determined, usually after a Series A funding round. In other words, startups can get fairly quick, low-interest cash which they repay with ownership equity at maturity.
COMPONENTS OF A CONVERTIBLE NOTE
A distinguishing factor of a convertible note from an ordinary note is the presence of a discount and a valuation cap in the transaction. These are terms that are fairly standard within a Convertible Note document and are used as safeguards by seed investors to protect their interests at the end of a financing round. We shall briefly explain these terms in the succeeding paragraphs.
A convertible note with a discount attached gives the investor an option to convert their seed money into equity at a lower price than the other investors. The discount is a feature that rewards early investors for taking larger risks than later investors. It does this by offering them the right to obtain shares at a cheaper price than what is to be paid by Series A investors once the financing round closes. When the convertible note converts to equity, not only do the investors receive credit for both their original principal and accrued interest, but they also get a discount on the price per share of the new equity. For instance, where a series A stock is offered at N500 per share, a seed investor holding a convertible debt with a 15 percent discount would convert their invested capital for N425 per share.
Another feature is the option of a valuation cap. This is a hard cap on the conversion price for early-stage investors regardless of the price per share on the next round of equity financing. This feature similarly rewards early investors but in a different way than the discount. The valuation cap sets the maximum value of a company when a round of financing closes, giving early investors an advantage. For instance, let us assume the Series A round sets a pre-money valuation at N20 million, and the cap on the convertible note is set at N10 million, with the stock price still offered at N500 per share. The seed investor will be able to purchase stock at N250 per share.
Seed investors can include a discount, a valuation cap, or even both in the convertible note. These features incentivize early investors as they offer two different ways to value their investment when the round of financing closes with a concrete valuation. If the convertible note contains both options, the investor may decide which is the better one that favors him and usually allows him to acquire more shares at the lowest price. Like in the above examples, the option that allows the investor to acquire more shares at the lowest price is the Valuation Cap.
Some other typical terms of Convertible Notes are issuance date, maturity date, and interest rates.
Just like any other debt investment, the invested capital earns a rate of interest. Although, when accrued, this interest is not paid in cash, which means that the value owed to the investor builds up over time. Some investors will include an interest rate in their convertible note to protect them against delays in startup valuation and ensure a return on their investment.
Considering convertible notes are still a form of debt, they have a maturity date like any other debt investment. This is the date on which the startup is required to pay back the initial investment if they have not already converted to equity. Some convertible notes even have an automatic conversion at maturity.
This is the date the terms of the convertible note come into effect.
It is very important to understand all the implications of the potential outcomes when using a convertible note as a seed investment. As a startup founder and seed investor, things can easily get complicated. Being able to understand the basics as set out above will save you from running into problems later. Also, by getting familiar with the complexities of a convertible note, you can arm yourself with the knowledge necessary to guide your startup through the difficult initial stages to where you hope for it to be.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.