When a startup or emerging growth company is seeking seed funding it typically needs to give up some equity or shares in the venture. The problem is that at the moment a startup is needs this seed money to grow, the company's stock cannot be valued accurately, so selling shares can be difficult because the future value of the shares isn't easily determined.
A convertible note is a form of short-term debt that, in certain circumstances, can be converted into equity in the company (typically when a later financing round occurs or other specific milestones). They are instruments that have grown quite rapidly in popularity over the past few years because they are much more simple and less expensive to use than selling equity. Although they have similar features as equity, convertible notes are actually debt instruments with terms that address company capitalization, discount rates, interest accrual, maturity, procedures concerning insolvency, and subordination.
Difference Between a Convertible Note and a SAFE:
The function of Simple Agreement for Future Equity or SAFE is meant to simplify what a Convertible Note does and to reduce the time and cost of execution of the loan that a convertible note provides. A convertible note is a proper debt instrument or a short term loan that can be converted into an equity stake, whereas a SAFE is simply a written agreement between an investor and the startup with a valuation cap provided for the conversion of a SAFE into equity. Unlike SAFE, however, being a debt instrument, a convertible note also comes with debt mechanisms, specifically an interest rate at which the debt is borrowed at and a maturity date by when the debt must be repaid.
Convertible Note Key Terms:
A valuation caps states a maximum dollar amount at which the company will be priced at to award the equity portion to the convertible note holder in exchange for the loan they provided. If a convertible bond has a valuation cap any upward change in the value of the company will not affect the price of the equity that the bondholder is awarded. So, if a convertible note has a valuation cap of say $5 million and the company closes its first round at a valuation of $8 million, the convertible note holder will be awarded an equity state proportionate to $5 million only.
The discount amount is the percentage at which the price of the share of the company is discounted for the convertible bond investor to purchase when it's time for the bondholder to convert the debt into equity. So, if the discount rate is 25% and the shares of the newly formed startup are being sold at $1 per share, the bondholder can purchase them at 25% discount that is $0.75 per share. In other words, for a $100,000 convertible bond at a 25% discount the bondholder will get 1333 shares of $100.
Convertible Notes and Dilution of Ownership:
Whenever a company borrows new money or seeks investment it dilutes the share of current owners. This is especially true of convertible notes. Convertible notes although start out as debt end up as an equity stake in the company. It can be a double edge sword in certain circumstances whereas a debt it enjoys the security of its terms to be paid back at the maturity date, but as a convertible instrument into equity, with severe terms, it can wreak havoc in diluting stake of the current owners. The borrowing company needs to look closely at both the discount rates and valuation cap when deciding use this form of financing.
Advantages of a Convertible Note:
Business ventures in general and startups, in particular, are risky. In a risky and complicated venture, deal-making and negotiations are fairly labor intensive and expensive to execute. In such an environment, Convertible Notes are relatively simple and less expensive to execute. Equity rounds require extremely competent legal counsel that tend to be time-consuming and very expensive. In exchange for going through a whole round of equity funding, the investors use convertible notes to get capital quickly, without the time and expense that a stock sale would require.
Delay in Valuation:
Owners of a company want to avoid diluting their ownership stakes by unnecessarily selling shares in their company. Thus, timing the valuation of your company correctly is extremely important to a startup. Time it too early and someone can pick up lion’s share of equity in your company for peanuts because the company's future and operations were too young to be fairly valued. A Convertible Note allows you to time the valuation of your startup and helps raise the amount of investment you can attract at various rounds of funding.
To Raise Funds in Between Rounds of Funding:
Convertible notes also allow a company to raise limited funds for an emergency or much-needed investment in infrastructure between financing rounds. This allows the company to continue to innovate and to get their hands on the most sophisticated way to introduce their product to the market for a successful launch.
Disadvantages of a Convertible Note:
Obligation to Pay:
It is important that both the company and investors understand that a convertible note is a debt instrument with an obligation to pay by the maturity date. Yes, it is true that most convertible notes automatically become equity, but many do not. If the company decided to or is unable to get equity financing round in time and burns through cash quickly, a convertible note could mean an end to the life of a company very quickly.
In the above scenario if the company does not get traction in the marketplace with its product or idea it either goes out of business or gets acquired for a nominal amount both of which means a painful end to an ambitious dream of many.
A Convertible Note Forces a Floor on the Valuation of a Company:
The valuation cap of a convertible note is essentially the floor of how much funding a company needs to raise in the next round. In some cases, with very high valuation the discount rate and valuation can force the company to accept unfavorable financing terms because the discount and the valuation cap make it possible for the note holders to walk away with large stakes compared to what the company is worth and what was loaned.
In conclusion, a convertible note is a valuable debt instrument in order to quickly raise funds to get startup funds to smoothly maintain the cash flow they need to operate on a day-to-day basis. However, poorly thought out terms, desperation, major changes in technology or market conditions, or unfavorable turn of events can make a simple convertible note into an albatross around a company's neck.