Convertible note template
In this article, we will discuss one such popular investment instrument which enables seed-stage funding for startups and how to use a convertible note template to create your own notes on Eqvista.
Companies need capital to operate. If the company is an established business, investors vie for their shares. But what happens in a startup scenario when the business is just starting out? Is there a way of financing startups simply based on the merit of the business idea?
Convertible note template or agreement
One of the most difficult tasks for a startup founder is to raise funds, more so in the early stages of the operations. At this point, the business idea has just started gathering momentum and will take some time to expand into viable operations. With little data to base on, the startup cannot be truly evaluated for its worth, shares cannot be issued, and it becomes difficult to attract investors. Convertible notes have evolved as an answer to this situation.
What is a convertible note?
Convertible notes are investment instruments in the category of debt-equity. These are issued to companies in the form of loans that will eventually convert into equity. They are different from business loans as the returns are not in cash, but shares in the company. As they are basically loans, convertible note terms outline how the interest will accrue and how the investor profits from the accumulated principal amount and the interest, all of which converts into equity on the maturity date.
Convertible notes are mostly used by startups as an initial stage funding when it is not possible to provide a proper company valuation. Startup operations take time to expand, making exact valuation difficult at the idea stage. Since company valuation is the basis of issuing shares, it becomes difficult to raise capital at an early stage without it. Convertible note agreements are designed to meet this purpose.
Some benefits of using notes are:
- Convertible notes enable startups to convince investors about financial aid in the early stages of their operation. Special terms are offered that make the investor’s waiting period towards equity conversion worthwhile.
- Founders and investors are not forced to wait for company valuation at a stage when the startup is still an idea. Sufficient funding at this stage allows the company to scale-up its operations making company evaluation substantial and worthwhile in the later stages.
- Economically as well as from the legal perspective, convertible note terms require less documentation as compared to a proper funding round.
Convertible notes are defined by four important terms: interest rate, conversion rate, valuation cap, and maturity date. We will discuss these in detail in the later sections, but note that it is difficult to create a universal template for convertible note agreements. Thorough knowledge of the terms is crucial before signing a fair deal. However, some basic aspects are common in all agreements.
What is a convertible note agreement?
As mentioned earlier, a convertible note template or agreement is only a starting point for startup founders attempting to raise capital using convertible notes. These agreements are not strictly a legal document and the terms vary with jurisdiction. Hence, a startup has to be acquainted with nation-specific provisions before engaging in these negotiations.
It is advisable to engage legal counsel while creating a loan agreement. Convertible note agreements are either lender friendly or borrower friendly and the terms profitable for one will be expensive for the other.
Important terms in Convertible Notes
Convertible notes eventually convert into equity, so startup founders have to be careful about the extent of dilution. More the terms in favor of the investor, the higher the conversion into equity, and the more extensive the dilution. Based on this, the following four important terms that function as negotiable levers in convertible note agreements have to be dealt with.
- Interest rate – Since convertible notes are debt instruments, they are legally required to carry interest rates. This is the profit-making mechanism for investors. With interest rates levied, notes function as a regular business loan, with exception to SAFE and KISS (to be discussed in the next section). Terms are negotiable. Hence the investors and the startup have to make informed choices.
- Conversion discount – Investing in convertible notes in the early stages of a company is quite a risky proposition for an investor. As compensation, this discount feature offers a special valuation discount for the investors in the subsequent valuation round. This is not offered to later-stage investors.
- Valuation cap – Convertible notes convert into equity on maturity. Keeping this in mind, the valuation cap feature proposes a predetermined lower share price to be used while converting the notes at maturity. If the business performs well, the share price will appreciate and the investor would have earned more equity with lesser investment.
- Maturity cap – This is a deadline for the preferred round. A particular date is set in the convertible note terms when the company has to pay back its investors converting their investments to equity.
Sample convertible note template
Despite being a quick fundraising option for startups, convertible notes carry substantial risks as well. No matter how brilliant the business idea is, a startup’s future is quite unpredictable. The majority of them fail within the first year of operations. On the other hand, since startups are cash strapped and in desperate need of funds, there are chances of them falling prey to investor demands that cut into the shares of the founding members. Hence, to ensure that neither party gets exploited in the process, terms of the convertible notes have to be negotiated thoroughly and agreed on paper. Here is a typical sample of a convertible note agreement.
Convertible note, KISS, and SAFE
As an alternative to convertible notes, two other forms of debt-equity instruments (SAFE & KISS) are becoming increasingly popular among startups for raising seed capital. These are model legal documents used by early-stage companies and are available for free download from the internet. The sole purpose of these resources is to simplify, standardize, and reduce the costs of sourcing seed financing.
KISS stands for Keep It Simple Security and was developed by the startup accelerator 500 startups. While SAFE stands for Simple Agreement for Future Equity developed by startup accelerator Y- Combinator. All these three documents have been created as a standard form document, which means that there are fewer negotiating points between founders and investors. These documents can be organized quickly and funding becomes simpler. Let us compare their unique features:
|Features||Convertible loan note||KISS||SAFE|
|Equity funding round||Investment either converts to common stock at lesser cap or discount or is returned as it is with or without interest.||At an equity round of new money beyond a specified amount, investment converts into preferred stock at a conversion price lesser of the valuation cap or discount.||At an equity round of any size, investment converts to preferred stock at a conversion price lesser of the valuation cap or discount (in case specified in SAFE document).|
|Sale of the company||Investment either converts to common stock at the cap or is paid back as it is with or without interest||Investment either converts to common stock at cap or is returned as a multiple of the initial amount. Some KISSes may allow an option of repayment.||Investment converts to common stock at cap or is paid back as original amount.|
|Specific investor rights||As agreed on the loan notes, there are many offered.||Right to information on company financials and right to participate in all future equity rounds.||Right to participate after the next equity funding round.|
|Higher resolution financing (preferred as per investor)||Yes||No. All KISSes in each series have identical rights.||Yes|
Create convertible notes on Eqvista
Eqvista enables founders and entrepreneurs to easily issue and manage shares on a unified platform. Eqvista’s user-friendly interface allows you to manage all shares of your company including convertible debts. Issuing convertible notes involves three simple steps:
Step 1: Create a free account and company profile here. This will lead you to the main ‘dashboard’. On the sidebar, click ‘securities’ and then on ‘convertible instruments’. The following page will open displaying all the convertible notes of your company. If you are a startup, issuing for the first time, click ‘issue instrument’.
Step 2: Next you will reach a page where you can issue and set up a convertible note.
Fill in the required information as below:
- Instrument Holder – Mention the investor here to whom the note is being issued. If you have not added them yet, read this article about how to do so.
- Convertible Note Name
- Issue Date
- Note Type – Either Standard Note, SAFE or KISS
- Principal – The original loan amount.
- Interest Rate (if applicable) – Interest rate levied on the principal amount
- Maturity Date – The date when the company has to pay back the note holder.
- Accrual Frequency (if applicable) – The frequency of the interest amount.
- Converts to – The type of stock that the convertible note converts to.
- Conversion Trigger Amount – The minimum amount that will trigger the conversion rate.
- Valuation Cap – The maximum company valuation when converting the note to shares.
- Early Exit Multiple – The guaranteed multiple of the principal paid out.
- Conversion Discount – The discount that is applied to the purchase of shares.
Step 3: Once all these details are filled in, click ‘submit’. You have just created and issued a convertible note to your investor! You can then go back and see your newly created convertible note.
As you can see, Eqvista makes issuing and managing convertible notes very simple. This is in addition to managing shares of the company. From an entrepreneur’s perspective, enabling access to all equity-related processes under one umbrella saves a lot of time and streamlines the approach. Issuing convertible note agreements have never been simpler. Here is how you can easily issue and modify convertible notes. For further queries, reach out to us today!