What Are Convertible Notes?
Convertible notes are a type of debt instrument commonly used by startups to raise capital during their early stages. It involves investors lending money to a startup with the intention of converting it into equity at a later milestone, often the next equity financing round. They offer a way to secure funding without immediately determining a startup’s valuation. Instead, valuation is determined when the note converts into equity.
What Are The Conditions Associated With Convertible Notes?
Several conditions come into play:
- Conversion Trigger: The event following which convertible notes are converted into equity, such as the next equity financing round or a specific maturity date.
- Conversion Price: The price at which convertible notes convert into equity. This may be determined by applying a discount rate or be capped by a valuation cap.
What Is A Valuation Cap For Convertible Notes?
A valuation cap is the maximum valuation at which convertible notes can convert into equity. It safeguards investors, ensuring that they are not unfairly diluted if the startup’s valuation skyrockets in the next funding round. The conversion price is determined by the valuation cap and the price is determined by the subsequent funding round – whichever is lower.
What Is Discount Rate For Convertible Notes?
A discount rate is applied to the valuation of the next equity financing round to determine the conversion price of the convertible note. This rate provides investors with an incentive to take the risk of investing in the early stages. For example, if the discount rate is set at 20%, and the next funding round values the startup at $1 Mn, the conversion price for the convertible note would be $8,00,000.
What Is The Interest Rate For Convertible Notes?
They may carry an interest rate that accrues over the note’s term. This interest can either be paid upon maturity or converted into additional equity when the note converts.
What Is The Maturity Date For Convertible Notes?
They come with a maturity date, which represents the point at which the note must either convert into equity or be repaid to the investor. If the startup has not reached a trigger event by the maturity date, the investor has the right to demand repayment.
What Are The Advantages Of Convertible Notes?
- Simplicity and Speed: They offer a streamlined process for raising capital, making them ideal for early-stage startups.
- Delayed Valuation: By deferring valuation discussions, startups can secure funding without facing the challenges of early-stage valuation.
- Flexible Terms: They allow for the negotiation of various terms, accommodating both startups and investors.
- Attractive to Early Investors: Early investors can benefit from favourable conversion terms, incentivising them to support the startup’s growth.
When To Use Convertible Notes?
They are instrumental in the following scenarios:
- Early-Stage Funding: For startups seeking rapid capital infusion in their early days.
- Uncertain Valuation: When a startup’s valuation is uncertain or difficult to determine.
When To Avoid Convertible Notes?
They may not be the best choice in these situations:
- Mature Startups: Equity rounds might be more suitable for startups with a solid track record and established valuation.
- Complex Financing Needs: If a startup requires a structured financing solution that convertible notes cannot accommodate.
