Many people might not be familiar with the term ‘Convertible Note.’ So, they want to know what is a convertible note and how it works. Seed financing is a common term used by start-up businesses and investors. This is the golden age for seed financing. Everyone, including angel groups, super angels, seed funds, incubators, venture capital funds, and others, is playing the same game.
Investing in start-up businesses can help you to get something like Facebook in the future or a loss, but you never know. The term convertible note is used by seed investors commonly. They are designed as a loan that is intended to convert into equity. The loan’s outstanding balance automatically converts into equity after a particular milestone.
It mostly happens in the later funding round valuation to compensate for the risk that angel investors have taken by investing in the past round. They might also have some additional clauses like discounts or caps. However, if you are looking for an answer to what is a convertible note, you have to know much more.
Everything You Need To Know About Convertible Note
As mentioned above, you need to know many other things and details about the convertible note to fully understand it. However, you can take a look below to understand all the details of what is a convertible note.
What Is A Convertible Note?
It is a debt of short-term that eventually becomes equity. It automatically turns into equity after a specific time period for the risk bearers. In short, investors loan an amount of money to start-up businesses. After the first round of financing, they convert the money into shares of preferred stock instead of getting money and interest.
The whole process is done based on the note of terms. It is beneficial for investors as well as businesses. However, as the investors bear the risk of losing their money, they get the upper hand. They receive the initial preferred stock of financing of the startup.
Advantages Of Convertible Note
There are many different advantages of a convertible note available. Among all those, the common ones are simplicity, speed, and cost.
- The startup business can close the convertible note in less than 2-3 days. They can issue a promissory note of 2-4 pages and pay the legal fees around merely $1500 to $2000 to close it.
- However, the preferred stock shares issuance is a complex method, and it can take more than 1-2 weeks to complete. Along with the time for arranging documents and negotiating terms, the legal fees will be around $10,000 to $30,000.
- Another crucial advantage of a convertible note is that it helps avoid giving any type of control to the investors. When the investors receive preferred stock shares, they also receive some rights such as veto rights, a board seat, and others.
- It offers extraordinary and excellent flexibility in raising round and prospective investors’ connections. Convertible notes have made possible variable pricing. It is so easy to close as they can set different prices for every investor. Many investors wait to see who else is planning to invest in the share.
Are you still confused about what is a convertible note? Here are some disadvantages of it that might help you to understand it fully.
Disadvantages Of Convertible Note
Along with all these advantages, there are many disadvantages available in a convertible note that you need to know. Some of the most important ones are given below in detail.
- For any reason, if the round of equity is not finished, then the convertible note will still require redemption, and debt will remain. It will push the company towards bankruptcy. So, it would be best if you think twice before choosing this.
- There are some clauses like conversion discount and valuation cap that can complicate the matter in the future by anchoring the price expectations. Future equity raises will not be as smooth as expected.
- If you are confused about the first disadvantage, then you can set the terms and conditions accordingly. You can set the terms that if it is taken too far, then the convertible note purpose will be canceled. Instead, needed time can be given along with effort as a regular or traditional round of equity.
Got the idea of what is a convertible note? However, there is still more that you need to know before you apply it. The investors receive some clauses along with the equities, right? What are the clauses? Let’s take a look at all the clauses.
Clauses Of Convertible Note
When you are thinking about convertible notes, there are some things and critical parameters that you need to keep in mind. The most common ones are listed below with some details.
1. Discount Rate
In the financial subsequent round, investors get a valuation discount. It is to compensate the investors for taking additional risks for investing earlier.
2. Interest Rate
There will be interest in the convertible notes as you are giving a loan to a company. However, the interests will not be paid back as money or cash. Instead, it will be added while issuing shares at the time of conversion based on the total principal invested.
3. Valuation Cap
It is an additional gift for the investors for bearing the risk in the early round. It effectively caps the total price in which the notes will transform into equity. Also, provide an upside like equity when the company does take off.
4. Date Of Maturity
It denotes the due date of the note. At which the company that took the loan needs to repay it.
Now you know all the details about what is a convertible note, decide if it is suitable for your business or not.
A convertible note is one of the most common terms for investors and startup businesses. It helps both the pirates to get an easy loan and close the deal after a particular period. Please go through the advantages and disadvantages to know more about it. You can learn other details too from this article to decide for your business or investment.