Getting funding is one of the main concerns of any startup, as it can determine their ability to successfully grow over time. Convertible notes are one type of funding that has become increasingly popular in recent years, especially among early-stage startups.
But what exactly is a convertible note? And how can it benefit your startup?
What Is a Convertible Note?
A convertible note is a form of debt financing where short-term debt is “converted” into equity.
While traditional loans need to be repaid with interest, convertible notes do not have to be paid back in the traditional sense. They convert into equity in the issuing company.
This conversion can take place at the founder’s discretion, but it usually happens automatically when the company reaches a certain milestone (e.g., valuation).
What Are the Benefits of Convertible Notes?
Convertible notes can benefit both the business and the investors. Let’s quickly run through some key benefits for both parties:
Benefits for Businesses
The main benefit of using convertible notes as a business—especially as an early-stage startup—is that they remove the pressure of paying off debts immediately.
As we mentioned before, convertible notes convert into equity at a later date. This means that businesses can have more time to grow the company and generate revenue.
Another major benefit of convertible notes is that they can help businesses to attract more investors. This is because convertible notes are often more attractive to investors than equity financing, which is usually much more difficult to navigate for businesses.
Benefits for Investors
Convertible notes are also beneficial for investors, as they offer a higher potential return on investment (ROI). This is because convertible notes often come with discount rates (more on that term later), which allow investors to get more equity for their investment than they otherwise would have.
Another advantage of convertible notes is that they offer a higher level of liquidity than equity financing. This means that investors can more easily cash out their investment if they need to, which can be helpful in the event of an emergency.
Lastly, convertible notes can help to reduce the risk for investors. This is because convertible notes are often structured in such a way that the investors’ downside is protected (e.g., through a “cap”).
Important Terms in a Convertible Note
We’re almost ready to put all of this information together to give you a complete picture of convertible notes.
But before we do, we need to go over a few key terms and concepts:
A discount rate (a.k.a., conversion discount rate) is the discounted rate that the convertible note holder will get when converting their debt into equity.
For example, let’s say that a convertible note has a discount rate of 20%. If the issuing company’s shares are worth $25 at the time of conversion, the convertible note holder is able to convert the note to equity at a price of $20 per share.
A valuation cap is a pre-agreed upon maximum valuation of the company at the time of conversion. This valuation cap protects the convertible note holder from overpaying for their equity when the company converts the debt to equity.
For example, let’s say that a convertible note has a valuation cap of $5 million, but the issuing company has a valuation of $10 million and a share price of $10 at the time of conversion.
The valuation cap ($5 million) is divided by the valuation ($10 million) and multiplied by the share price ($10) to calculate the discounted rate that the convertible note holder will get. In this case, this will be $5 per share.
An interest rate is the percentage of the convertible note’s principal that will accrue interest over time. This interest is generally paid out in shares when the convertible note matures or is converted to equity.
For example, let’s say that a convertible note has an annual interest rate of 5%. If the principal of the convertible note is $100,000, the interest that accrues over one year will be $5,000. This $5,000 would be added to the principle when converting the debt to equity.
A maturity date is the date on which the convertible note will mature and be paid back in full to the investor.
For example, let’s say that a convertible note has a maturity date of three years. This means that, after three years have passed, the convertible note will be fully converted into equity and repaid to the investor.
How Do Convertible Notes Work?
Now that we’ve covered the basics of convertible notes, it’s time to put it all together with an example. We’ll try to keep things simple, but will include all the concepts we’ve covered so far!
An investor invests $100,000 in a convertible note with the following terms:
- Valuation Cap: $6 million
- Discount Rate: 20%
- Maturity Date: 5 years
- Interest Rate: 6% annually
After 5 years, the company is valued at $8 million with a share price of $20. The conversion would go something like this:
Step 1: Calculate Interest
This part is relatively easy. Simply multiply the convertible note’s interest rate by the number of years that have passed since the convertible note was issued. In this case, we would multiply 6% by 5 to get an accrued interest of 30%.
This means that the convertible note’s principal has increased from $100,000 to $130,000.
Step 2: Calculate the Conversion Rate
Now we need to convert the convertible note into equity. To do this, we need to calculate the convertible note’s conversion rate (i.e., the discount that will be applied to shares).
Here, there are two possible rates: the discount rate and the valuation cap rate. Some convertible notes will offer the investor one or the other, but in this case both are included. We need to calculate both and choose the lowest of the two:
- Discount Rate: 100% – 20% = 80%
- Valuation Cap Rate: $6 million / $8 million X 100% = 75%
In this case, the valuation cap rate of (75%) is lower. This means that the share price will cost the convertible note holder 75% less than the usual price.
Step 3: Convert the Note To Equity
Now that we have the convertible note’s conversion rate, we can convert it to equity. To do this, we multiply the company’s share price of $20 by the 75% discount to get a $15 discounted share price.
We then divide the $130,000 principle by the $15 discounted share price to get 8,667 shares. These are the number of shares that the convertible note holder will receive through the equity conversion.
If the investor hadn’t used a convertible note, that same $100,000 investment would only be worth 5,000 shares—definitely a big difference!
Convertible Notes Can Unlock Startup Growth
Convertible notes can provide an easy way to finance your business without the complexity and time involved in many startup financing rounds. This financial instrument can help founders focus their efforts towards growing their business and providing value to their customers.
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