Convertible Notes
A type of short-term debt that converts to equity after a conversion event occurs (usually when the startup raises a new round of funding)
Developed to lower the cost and speed of early stage investing, convertible notes are a hybrid structure. In practice investors do not want repayment, but rather they expect the company to raise equity capital and convert their debt into equity with preferable terms.
Convertible notes vs. standard loans
Convertible notes are not like standard loans which are typically backed by assets or priced based on credit history. But startups rarely have these types of assets, so traditional loans are often an option.
Investors are rewarded with options on future rounds of funding. The note specifies how an initial loan principal plus interest is converted into equity with a discount and a “valuation cap” or capitalization.
Investors are promised a discount on the future value of equity when the company does raise capital through a major event, like a Series A raise. The discount is the reward granted to the investor for taking risks on a very early-stage company.
The valuation cap also rewards early investors for their disproportionate risk by setting the maximum value of a company to when its formal equity investment round closes. When a later stage equity investment closes, investors can choose between the lower of either the discount or the cap conversion when it’s time to convert debt into shares.
Seed equity vs. convertible notes
Startups that need to fund operations ahead of revenue or alongside revenue may choose to raise a convertible note vs. seeking direct equity investment from angels, friends, family, or other early-stage seed investors.
Prior to convertible notes, startups would have to prove the overall value of the company in order to calculate the value of the shares, also known as the company’s valuation. At the earliest stage, with early but uncertain revenue or no revenue, it is difficult to evaluate a company because all of the value lies in the future potential. While the discount and cap numbers mentioned provide an indication of the value of the company, the startup can avoid costly legal fees and the formality of valuation to speed up the deal negotiation process for early funding.
Example Investors Using Convertible Notes
Angel Groups | Independent Seed Investors | Some Accelerators
Are Convertible Notes the right capital for your business at this stage?
COMPANY PERSPECTIVE
Benefits
- Simple to document legally, the administration is less expensive than an equity investment
- The company can delay formal valuation
- Speed and access to capital
- No change in voting rights: startup management can decide how to spend and plan investment without investor input
Challenges
- You're on the clock - a time frame is set to convert debt to equity
- Misalignment of incentives may create conflict and encourage companies to seek out a higher valuation in order to dilute early investors
- Some convertible note structures cause problems if the startup does not raise capital before the maturity date
Key Performance Indicators
- Discount Rate
- Valuation Cap
- Maturity Date
CAPITAL GIVER PERSPECTIVE
Benefits
- Fast negotiation, standard terms
- Many high potential fast-growth companies prefer convertible notes over equity
- An option bet on a high-risk but high-potential company, but with set prices and discounts
Challenges
- No governance rights - startup management has full decision authority for how to spend the funds
- Early-stage startups act as complex adaptive systems with unpredictable elements, frequent changes in data
- Many notes do not specify what happens if the company cannot or chooses not to raise subsequent equity financing
Key Performance Indicators
- Discount Rate
- Valuation Cap
- Maturity Date
When it Works Well
Speedy transaction
In startup ecosystems where this structure is in use, the Convertible Note is well known and angels and lawyers know how to think and negotiate quickly.
Company valuation and investor voting rights occur with equity investing, but Convertible Notes do not require a great deal of paperwork to negotiating these terms. Legal fees are minimized and the funding round can be quickly closed as well.
Funding before traction
For founders building software startups, there is an early development stage that usually precedes the generation of evidence of customer demand or financial results. It is therefore difficult to evaluate companies at the early stage outside of standard comparables to similar firms. Convertible notes delay the valuation question until more evidence is generated.
Fills a funding gap
Business models like marketplaces, offering a free-to-premium or freemium model, advertising, or pay-per-use often have lower revenue growth at the earliest stage before network effects and audience becomes large enough to increase the volume of growth and audience engagement. These types of companies typically are not ideal for revenue-based finance options because their unit economics are not favorable to this type of financing.
Challenges to Convertible Notes
Clock starts ticking
Founders who do not do their research may realize too late that they are not taking out a loan. The maturity date indicates an expected date for a formal larger scale Seed or Series A round, which would be priced as an equity round of funding. Failing to meet this date may signal that the startup is taking too long to find product-market fit. Failure to plan for this inevitability may result in complex negotiations as your debt becomes due and interest continues to accrue.
Not great for so-so growth
Convertible Notes work for companies that fit the fast growth mold: 30%, 100% or more Annual Recurring Revenue. That’s what Venture Capitalists who invest in Series A rounds are seeking, and there are many companies that fall into the “Valley of Death” never to emerge. If that’s the case- the company goes into bankruptcy, and you are essentially forgiven.
But if your company is growing at 5%, you will not be attractive to Venture Capitalists, and you may choose to pay back your loan, but this may cause friction with your investors, and create a burden on your ability to shift to profitability. It’s a perverse disincentive for a founder who realizes that they may have a decent slow growth profitable business, but not a future rocket ship.
Dilution ratchets
Beware of ratchets that limit the investors’ dilution, while you the entrepreneur have an unlimited downside. If you fail to raise a well-valued round in a market downturn, or because you are proceeding at a slower pace than you had planned, you may lose more control of the company than you had planned.
Trends in Convertible Notes
Popular despite early investor concerns
When Convertible Notes first came to startup investing, many prominent VC and early-stage professional angel investors resisted the structure, insisting that certain terms created misalignment for the seed and subsequent rounds of funding, and publicly insisted that they would not invest in this type of instrument. However, the need for speed and lower cost of legal fees won out and Convertible Notes continue to be a popular financing option in many startup ecosystems.
Rise of the SAFE note
SAFE notes or “Simple agreement for future equity” were developed by the accelerator Y Combinator as an alternative to convertible notes. These instruments are not categorized as debt, nor are they equity. While the SAFE features a discount and valuation cap, there is no need to set an interest rate or fix a term. SAFE is popular in the Bay Area, Boston, and NYC but then spread to other cities has been prevented by traditional investment managers and lawyers who do not like the loose terms of this non-equity, non-debt instrument.
Before You Consider Convertible Notes
- Do you have clear terms for what happens if your startup fails to raise capital before the maturity date?
- Are you aware that you will be expected to raise a round of venture capital and that not many companies achieve this goal?
- Are you ready to be “on the clock” on the path to raising additional rounds of equity?
Exploring Convertible Notes
- Ask fellow founders if Convertible Notes, SAFE notes, or equity is more prevalent in your startup ecosystem.
- Ensure you have a lawyer that is familiar with Convertible Notes and has a predictable pricing structure to support you through your early-stage fundraising.
Discover Alternative Capital
Convertible notes are one way to grow your company, and you can choose other capital types as an alternative or pair and combine at different stages of your business. Consider these alternative capital sources or explore our Capital Library.
