When you’re building a startup, you need plenty of operating liquidity to hire employees, purchase equipment, rent office space, and maintain inventory. And as your business grows, so will your expenses. Finding working capital for day-to-day operations can be difficult if you're not ready for a valuation or to issue stock.
Fortunately, you can secure funding without performing a full business valuation. By guaranteeing a discount on future stock issuance, convertible notes help you attract investors, giving you the necessary funds to grow your startup. However, you’ll need to set the terms of the note carefully to maximize its long-term value.
Below, we’ll provide a basic convertible note definition and some examples of the conditions that trigger conversion.
What is a convertible note?
A convertible note is an investment tool used by early-stage startups that convert its balance into equity when certain conditions are met. Since these startups are not yet at a stage when a proper company valuation can be performed, they typically issue convertible notes to early investors. The investors then get repaid with equity in the company rather than direct principal and interest. In most cases, the note will convert to equity when the business closes its Series A round of financing.
For startups, this is a way to gain working capital without immediately issuing stock or requiring a business valuation.
How do convertible notes work?
Convertible notes usually convert into preferred stock automatically — most commonly after a financing round or the issuance of preferred stock to other investors. Investors take on a significant degree of risk when purchasing convertible notes but reap the reward via the terms of the agreement. Most convertible notes have two mechanisms for rewarding risk: A conversion valuation cap and a discount rate.
A valuation cap places a maximum on the startup’s value during the next round of financing. For instance, if a convertible note has a valuation cap of $5 million and the actual valuation is determined to be $10 million, the noteholder can purchase stock as if the company was valued at $5 million.
Discount rates provide a straightforward discount on stock price, expressed as a percentage. Here’s a convertible note example using a discount rate as a primary parameter:
- A startup issues a convertible note with a discount rate of 20%.
- The business is valued at $5 per share during Series A funding.
- Series funding automatically triggers the conversion.
- Investors who purchased the convertible note receive a price per share of $4.
Convertible notes can contain both valuation caps and discount rates. In such scenarios, the investor can choose one of the reward mechanisms—but not both. In other words, the investor receives the best price per share available under the agreement, but the stock price is only discounted once.
Benefits Of Convertible Notes
Savvy investors will need a guarantee that they’re not throwing their money away. An objective analysis of your business’s value can provide that guarantee. However, valuation may be difficult or impossible at the early stages of a startup.
The founder might have an excellent idea and a solid execution plan, but until the product has been developed and brought to market, the value of the business is mostly subjective. If you begin business valuation too early, the valuation will be low, and you may need to engage in extra rounds of funding later on. Too many rounds of funding can scare off future investors.
Additionally, series funding is an expensive and time-consuming process. Most companies can expect to pay $7,000 to 20,000 or more for business valuation, legal fees, and other expenses.
A convertible note is much less expensive and significantly less complicated than series funding. Since a convertible note doesn’t require valuation, it’s a quick way to get the capital you need for hiring employees or performing other essential activities.
Other advantages of convertible notes:
- Since convertible notes are short-term debt, investors usually don’t receive veto power or other controls over business operations.
- If your startup needs to raise funding between larger rounds, convertible notes are ideal for obtaining those funds quickly.
- Convertible notes have a simple structure and fairly straightforward tax implications for investors and issuers.
The bottom line: Convertible notes have more advantages than disadvantages for startups. They’re a quick, flexible way to secure funding. If you’re unable to perform a fair valuation for your organization, convertible notes allow you to reward investors without sacrificing too much control of your business.
Disadvantages Of Convertible Notes
The major disadvantage of a convertible note is that the value of the underlying equity can vary significantly when the note converts. If you issue convertible notes with a low valuation cap, you might end up selling preferred stock at a much lower price than its fair market value. However, since you’ll need capital to get your business off the ground, the tradeoff may be worthwhile.
Other potential disadvantages of convertible notes:
- Convertible loans have interest rates that accrue over time. If qualified financing fails to occur within your anticipated timeframe, investors will be entitled to significant equity.
- Most convertible loans carry a maturity date in addition to the provisions for conversion. If your company hasn’t converted the note to equity before the maturity date, you’ll need to repay the note with interest.
- While conversion notes do not require a business valuation, the terms of the agreement may effectively place a “soft" value on your business. Future investors may reference the valuation cap when negotiating the terms of their investment.
Overall, convertible notes are an excellent instrument for startups. As long as you set the terms of the notes carefully, you’ll be able to get the capital you need to run your business without the complications of valuation and series funding. Of course, you’ll need accurate financial projections to set the terms of the convertible note appropriately.
Zeni’s AI-driven platform simplifies startup funding.
In order to issue convertible notes, your business will need accurate data about key metrics. Your current finances will help you determine how much funding to pursue and set terms for your convertible notes that reward investors without sacrificing too much of your business’s future equity.
Actionable financial insights will also help your organization pursue series funding while minimizing some of the associated costs. Eventually, investors will need to see your business’s basic financial statements; without diligent accounting, you may be unprepared to provide those statements, leading to costly delays or even threatening long-term business continuity.
Zeni provides a full-service finance team to help you start your business and bring your ideas to execution. By combining a powerful AI-driven platform with knowledgeable guidance from experienced accountants and bookkeeping experts, we provide startups with comprehensive services for seamless financial management. The Zeni dashboard enables founders to monitor budgets, create financial projections, and get intelligent insights that enable stronger business decisions.
Most importantly, Zeni provides peace of mind. Whether you’re issuing convertible notes or planning your initial public offering, you’ll have the resources you need to stay focused on your business.