Convertible Note
Definition
A Convertible Note is a a form of short-term debt that eventually converts into equity, typically during a future financing round. This tool is especially popular among startups as it provides a means of securing funding while delaying the valuation process until the company is more established and its valuation can be more accurately determined.
Convertible notes offer a flexible financing option without immediate equity dilution. It’s a strategic tool for managing ownership and control in the early stages of growth.
Startups, particularly in their early stages, often face challenges in accurately valuing their company. Convertible notes allow them to raise capital without immediately setting a fixed valuation.
For investors, convertible notes offer a way to invest in a startup at an early stage with the potential benefit of converting their investment into equity at a later stage, often at favorable terms. These notes provide an opportunity to invest in early-stage companies with potentially reduced risk, thanks to features like discount rates and valuation caps.
Key Features
- Interest Rate: This rate dictates the amount of interest accrued on the note until it converts into equity or is repaid.
- Discount Rate: Provides investors with a discount on the price per share when the note converts into equity, as a reward for the risk taken by investing early.
- Valuation Cap: Establishes a maximum valuation at which the note will convert into equity, protecting investors from dilution in high-valuation future funding rounds.
- Maturity Date: The date by which the note should either convert into equity or be repaid. This sets a timeline for the startup to achieve certain milestones or secure further funding.
Frequently Asked Questions
- How do convertible notes benefit startups compared to traditional equity financing?
Convertible notes allow startups to raise funds without immediately diluting ownership or establishing a fixed company valuation. This can be advantageous for startups in their formative stages, where valuing the company can be challenging and potentially undervaluing the business.
- What are the risks associated with using convertible notes for financing?
One risk for startups is the obligation to either repay the debt or convert it into equity by the maturity date. This can put pressure on the startup to achieve growth or raise further funds. For investors, the risk lies in the uncertainty of conversion terms and the future valuation of the company.
- What happens to a convertible note if a startup fails to raise another funding round?
If a startup fails to raise another funding round before the maturity date of the convertible note, the terms of the note will dictate the next steps. Typically, the note might be repaid as debt or, in some cases, it might convert into equity based on predefined terms agreed upon by the startup and the investors.
- What are some of the common types of convertible notes used in startup financing?
Traditional Convertible Note:
- Features: It usually includes an interest rate, a discount rate for future equity conversion, a valuation cap, and a maturity date.
- Usage: This is the standard form of a convertible note, providing debt that converts to equity under specific conditions.
SAFE (Simple Agreement for Future Equity):
- Features: Developed by Y-Combinator, a well-known startup accelerator, SAFE is not a debt instrument but an agreement to receive equity upon a future priced financing round. It doesn’t accrue interest and doesn’t have a maturity date, simplifying the terms compared to traditional convertible notes.
- Usage: SAFEs are popular for their simplicity and are often used in early-stage startup funding.
KISS (Keep It Simple Security):
- Features: Introduced by 500 Startups, another accelerator, KISS agreements can be debt or equity-based and aim to offer a balanced approach between SAFEs and traditional convertible notes. They include provisions like interest rates and maturity dates but are designed to be founder-friendly.
- Usage: KISS agreements are used as an alternative to both SAFEs and traditional convertible notes, offering a middle ground.
