Convertible notes are one of the most popular forms of startup funding due to their straightforward structure and predefined terms. In this article, we explore how convertible notes work, how they compare to other forms of startup financing, and how you can avoid some of the common pitfalls to maximize your next raise.
What is a convertible note?
A convertible note is a debt instrument with a short maturity date (usually between one to three years) that is converted into equity when certain conditions are met. They can be used throughout the lifecycle of a startup, but are typically used when the startup hasn’t raised a priced round. They enable founders to raise capital quickly without giving up too much equity upfront, which makes them an attractive option alongside SAFEs.
What is a reverse convertible note?
Reverse convertible notes are similar to traditional notes in that they are debt instruments and can be converted into equity, but there are a few key differences.
- Interest rate: reverse notes typically come with a higher interest rate compared to traditional notes.
- Repayment: with reverse notes, the startup can choose to repay the investor via stock or cash. With traditional notes, startups typically are only able to provide stock.
- Maturity: reverse notes do not have a set maturity date, traditional notes do. Reverse notes mature upon the balance being satisfied, traditional notes mature on or before a specified date.
The benefit of reverse notes is that they provide investors with a guaranteed return on their investment, regardless of how your startup performs. This makes it an attractive option for investors who are more risk-averse and don’t want to rely on your startup’s future performance.
How do convertible notes work and how are they structured?
Convertible notes work and are most similarly structured to SAFEs. Startups receive upfront capital in exchange for future equity when certain milestones are met. The amount of equity that the note converts into is based on a predetermined valuation cap. The terms may include:
- Maturity date: the date by which the note must be converted into equity.
- Valuation cap: the maximum valuation at which the note can ‘convert’ into equity.
- Interest rate: the interest that accrues during the life of the note. It must be repaid upon maturity.
- Discount: the discount rate, expressed as a percentage, outlines the discount that investors receive on the strike price of each share upon conversion.
- Capital investment: the amount of money that the startup receives in exchange for the note.
In most cases, convertible notes are exchanged for equity at maturity, however, it's important to note that investors may also redeem the note for cash in some instances. If redeemed for cash, the startup must repay the principal and all accrued interest.
Why do startups use convertible notes to raise capital?
Convertible notes are attractive to startup founders as they are relatively straightforward which minimizes the need for lengthy negotiations and streamlines the overall process. They’re also typically more flexible than traditional loans and other forms of startup financing, which means that they can be used for more than just operating expenses and inventory purchases. Most importantly though, they have a fixed maturity date and a maximum valuation cap, which means the equity exchanged is fixed and the subsequent dilution is minimized.
Requirements for a startup to qualify for a convertible note?
The requirements to raise capital through a convertible note are relatively minimal. Startups typically do not have to be profitable or even revenue-generating, they simply need to have a compelling story and demonstrate their upside potential. Startups may also need to be incorporated as a C corporation or S corporation.
What are the Benefits of Raising Capital via a Convertible Note?
Raising capital via a convertible note provides several benefits to startups.
- It is relatively simple and fast: since the terms of the loan are predetermined, there isn’t a need for lengthy negotiations or complex legal documents.
- It is flexible: the capital raised from convertible notes can be used for just about anything the startup determines is reasonable.
- It doesn’t need to be repaid immediately: since the repayment of the loan isn’t due until maturity or a qualifying event, the startup can focus on growing the business without worrying about repaying the balance.
- It’s attractive to investors: unlike other traditional loans with limited upside potential, convertible notes hypothetically have an unlimited upside. As your startup valuation grows, so does the equity that investors have in your business.
What are the drawbacks of raising capital via a convertible note?
Although convertible notes provide several benefits to startups, there are also a few drawbacks to consider.
- Dilutive: As mentioned above, convertible notes convert into equity and thus are dilutive to founders' equity.
- More expensive: Compared to non-dilutive forms of financing, convertible notes are more expensive in the long run.
- May complicate your cap table: because convertible notes haven’t technically been ‘converted’ yet, they may complicate your cap table equity calculations and contractual provision in future rounds—e.g. anti-dilution protection, pro rata rights…etc.
Can startups negotiate the terms of a convertible note?
Until the note is signed, the terms can and should be negotiated.
The interest rate, valuation cap, and maturity date are all negotiable. Consider pushing for a lower valuation cap and interest rate and a longer maturity date as this makes the deal more favorable. You’ll likely not be able to negotiate all three of these terms to end in your favor, but getting even one or two of them is a win.
Compared: convertible notes vs equity financing
- Dilution: While both equity and convertible notes are dilutive, the differences lie in the timeline from initial funding to the ultimate dilution. With equity financing, the dilution is immediate, whereas the dilution from convertible notes happens later down the line.
- Due diligence: Equity financing typically requires more due diligence and paperwork than convertible notes. This makes convertible notes a more attractive option for founders who need to raise capital quickly.
- Sizing: Equity financing typically provides more capital than convertible notes, which makes it a more attractive option for startups with large capital needs.
- Interest: Equity financing is not debt and therefore does not accrue interest, whereas convertible notes do.
Compared: convertible notes vs SAFE
SAFEs, like convertible notes, (Simple Agreement for Future Equity) are a form of financing used by early-stage startups to raise capital. While they are similar, there are some key differences.
- Valuation cap: While both notes and SAFEs have a valuation cap, SAFEs typically come with a lower valuation cap.
- Maturity date: notes have a maturity date, SAFEs do not.
- Interest: notes accrue interest, SAFEs do not.
- Sizing: notes typically provide more capital than SAFEs.
Compared: convertible notes vs venture debt
Venture debt is a type of loan that is typically used by startups to finance their growth. It is similar to a convertible note in that it provides the startup with capital that must be repaid with interest, however, there are some key similarities and differences.
- Dilution: Both venture debt and convertible notes can be dilutive. Whereas all convertible notes are dilutive, some venture debt deals might be if they require warrant coverage.
- Repayment schedule: Venture debt comes with a set repayment schedule. In some cases principal and interest payments are required, in others, interest-only payments are required. With convertible notes, typically no payments are required until maturity when either it's converted into equity or the balance is repaid.
- Sizing: Startups can raise more money with venture debt compared to convertible notes.
Compared: convertible notes vs revenue-based financing
While both convertible notes and revenue-based financing are popular forms of financing for startups, there are some key differences.
- Qualifications: To qualify for revenue-based financing, startups must generate revenue. Startups do not need to generate revenue to qualify for revenue-based financing.
- Dilution: Whereas convertible notes are dilutive, revenue-based financing is not dilutive.
- Sizing: Typically convertible notes are used to raise between $500k-$1M by startups, whereas startups can raise an infinite amount with revenue-based financing, as it scales with their revenues.
- Repayment: convertible notes typically do not need to be repaid, as they convert into equity upon maturity. Revenue-based financing on the other hand typically needs to be repaid partially each month until the balance is satisfied.
What are the common pitfalls to avoid when raising capital via a convertible note?
Raising capital via a convertible note can be a great way for startups to access the capital they need to grow. However, it is important to be aware of the common pitfalls to avoid when raising capital via a convertible note.
- Not negotiating terms: generally speaking, startup founders can negotiate at least one of the terms of the convertible note.
- Agreeing to a large discount rate: the larger the discount, the more shares an investor receives and the higher the dilution startup founders incur.
- Agreeing to a far out maturity date & high valuation cap: the further out the maturity date and the higher valuation cap, the more time that investors have to convert their note into equity. This extended timeframe leads to more accrued interest and a higher overall cost of capital.
Closing thoughts on convertible notes
Raising capital via convertible notes can be a great way for startups to access the capital they need to grow. Due to their lightweight nature, founders can typically close a new round of financing within weeks, compared to months with other forms of financing. In addition, due to their flexible nature and delayed repayment structure, startups can focus on building product and attracting customers, rather than worrying about repayments, which can be helpful for cash flow planning.
All that said, before raising capital via convertible notes, founders should confirm that their needs best align with this form of financing over SAFEs, venture capital, lines of credit, small business loans, crowdfunding campaigns, and other forms of startup financing.