What Every Founder Needs to Know About Convertible Notes

Are you a founder looking for a way to fund your startup? If so, you may have heard of convertible notes, a type of financing that can help you get the capital you need to get your business off the ground. In this blog, we’ll explain what convertible notes are, how they work, and why they may be the right choice for your startup. Read on to learn more about this popular form of financing.

What is a Convertible Note?

A convertible note is a type of short-term debt that can be converted into equity at a later date. It is usually used by startups to raise capital from investors without having to go through the process of issuing stock. The note typically has a maturity date and an interest rate, and the investor will receive either their principal plus interest or equity in the company, depending on the conversion terms of the note. The conversion rate is usually set at a discount to the valuation of the company at the time of conversion. The investor is then able to convert the debt into equity at the predetermined rate when the company reaches a certain milestone or when the company raises additional capital. Convertible notes are a popular way for startups to raise capital quickly and efficiently and offer investors the potential for a higher return on their investment.

What are the benefits of a Convertible Note?

It’s important that you understand the benefit of a convertible note from the company perspective and the investor perspective.

From the company’s perspective, the main benefit of a convertible note is that it allows companies to raise capital without having to value their company, issue shares and go through a lengthy legal process. This gives companies more time to focus on their business, develop their business and increase their valuation before issuing equity or worrying about the complexities of a traditional equity round.

From an investor’s standpoint, convertible notes may be attractive as it can provide investors with a higher return than traditional debt instruments. In addition, a convertible note may provide an investor with certain rights, such as the right to receive a higher conversion rate if the company raises additional capital.

What are the risks of a Convertible Note?

The main risk associated with a convertible note is that the company may not be able to raise additional capital at a higher valuation than the conversion price of the note. If the company is unable to raise additional capital at a higher valuation, then the investor may be able to convert the note into equity at a lower price than the company would have been able to issue equity for. This could result in the investor receiving a larger stake in the company than the company had intended. The company may also be exposed to the risk of default if the company is unable to repay the loan on the maturity date.

What is the process if a company wants to raise money from an investor with a Convertible Note?

The process of raising money from an investor with a Convertible Note typically involves the following steps:

1. Draft a Term Sheet:

Consult with your lawyer to draft a term sheet. A term sheet is a document that outlines the terms and conditions of the convertible note. The term sheet will typically include the amount of the loan, the interest rate, the maturity date, the conversion price, the conversion rights, and any other relevant terms.

2. Negotiate the Terms:

Once the term sheet is drafted, the company and the investor will need to negotiate the terms of the convertible note. This process may involve back-and-forth negotiations between the company and the investor until both parties are satisfied with the terms of the note.

3. Sign the Convertible Note:

Once the terms of the convertible note have been agreed upon, the company and the investor will need to sign the convertible note. This document will serve as a legal agreement between the company and the investor and will outline the terms of the loan.

4. Close the Deal:

Once the convertible note has been signed, the document is circulated to all parties and the investor transfers the funds to the company.

By following this process, a company can raise money from an investor with a Convertible Note and benefit from the flexibility that this type of financing provides.

What is included in a term sheet for a Convertible Note?

1. Amount of money being raised:

The term sheet will include the amount of money that the company is raising from the investor. This amount will be specified in the term sheet and will be the amount of money that the investor will loan to the company.

2. Interest Rate:

The term sheet will also include the interest rate that the company will pay on the loan. This rate will typically be lower than the rate that the company would pay on a traditional loan.

3. Maturity Date:

The term sheet will also include the maturity date of the loan. This is the date on which the company must repay the loan to the investor.

4. Conversion Price:

The term sheet will also include the conversion price of the loan. This is the price at which the investor can convert the loan into equity in the company.

5. Conversion Rights:

The term sheet will also include the conversion rights of the investor. This will outline the conditions under which the investor can convert the loan into equity in the company.

6. Other Terms:

The term sheet may also include other terms and conditions that are relevant to the loan. This could include provisions for early repayment, restrictions on the company’s ability to raise additional capital, and other relevant terms.

What are the terms of a Convertible Note?

The terms of a convertible note typically include the following:

1. The amount of money being raised: This is the amount of money that the investor is lending to the startup.
2. The interest rate: This is the rate of interest that the investor will receive on the loan.
3. The maturity date: This is the date on which the loan must be repaid.
4. The conversion terms: This is the terms under which the loan can be converted into equity. This typically includes the conversion price, which is the price at which the loan will be converted into equity, and the conversion ratio, which is the ratio of the loan amount to the equity amount.
5. The repayment terms: This is the terms under which the loan must be repaid. This typically includes the repayment date and the repayment amount.
6. The security: This is the security that the investor will receive in the event that the loan is not repaid. This could be a lien on the company’s assets or a pledge of the company’s shares.
7. The rights of the investor: This is the rights that the investor has in the event of a default on the loan. This could include the right to take control of the company or the right to receive the repayment amount plus interest.

What are examples of terms that are not founder-friendly in a Convertible Note?

1. High Valuation Cap: 

A high valuation cap means that the note holders will receive a higher percentage of the company’s equity when the note converts into equity. This can be problematic for founders, as it reduces the amount of equity they will receive in the future.

2. Discount Rate: 

A discount rate is the percentage of the company’s equity that the note holders will receive when the note converts into equity. A high discount rate means that the note holders will receive a larger percentage of the company’s equity when the note converts into equity. This can be problematic for founders, as it reduces the amount of equity they will receive in the future.

3. Maturity Date: 

A maturity date is the date at which the note must be repaid. If the note is not repaid by the maturity date, the note holders may be able to convert the note into equity. A short maturity date can be problematic for founders, as it reduces the amount of time they have to either increase revenue or raise additional capital to repay the note.

4. Interest Rate: 

An interest rate is the rate of interest that the note holders will receive on their investment. A high interest rate can be problematic for founders, as it increases the amount of money they must repay to the note holders.

5. Conversion Trigger: 

A conversion trigger is the event that will cause the note to convert into equity. A conversion trigger that is too restrictive can be problematic for founders, as it reduces the amount of equity they will receive in the future.

What happens if I can’t repay a Convertible Note?

If you are unable to repay a convertible note, the investor may choose to convert the note into equity in your company. This means that the investor will receive shares of your company in lieu of repayment. The amount of equity they receive is determined by the terms of the note, including the conversion rate and the valuation of the company.

It is important to note that the investor may also choose to pursue other remedies, such as legal action, to recover the money owed. This is why it is important to understand the terms of the note before signing it.

If you are unable to repay the note, it is important to communicate with the investor as soon as possible. This will help you to negotiate a repayment plan or other solution that is mutually beneficial. It is also important to understand the potential consequences of not repaying the note, such as the investor converting the note into equity.

Ultimately, it is important to understand the terms of the convertible note before signing it and to communicate with the investor if you are unable to repay the note. This will help you to negotiate a mutually beneficial solution and avoid any potential legal action.

Final Words

Being educated about convertible notes is essential for founders. You should always consult with your lawyer about your situation specifically since each business is unique. It’s important to understand the key terms included in a convertible note and the impact a convertible note could have on your business before you look for a seed investor, and it can help you negotiate a better deal!