This article would help you understand all about convertible notes and the typical convertible note terms. Keep reading to learn more about it.
There are a lot of different ways to raise funding in a company. But one of the most popular ways of raising funds is by offering investors convertible notes, especially if the company is a startup or during the early stages of development in a company. Using a convertible note, the investor would loan money to the startup, and in return, they would get an agreement to get paid the principal amount (plus an interest) with an option for future equity in the company.
What is a Convertible Note?
A convertible note is a kind of convertible security. Convertible securities are instruments that are expected to ultimately turn into stock. These include standard convertible notes, KISS’s (Keep it Simple Security), and SAFEs (Simple Agreement for Future Equity). And in this world of convertible securities, convertible notes take up a space that is known as debt-equity. Normally convertible notes act as an “I Owe You”, but instead of paying cash, you will have to pay in equity. Here is a much better explanation of convertible notes.
It is important to know when and why companies would use convertible notes. Let us assume that you have an awesome idea and you need an investor to help you in building that idea into a business. It would be really hard for you to issue stock to the investor since there is no real way to give the stock value.
This means that if you have an idea, there isn’t anything that can help in finding out about the stock. And because of this underlying problem, convertible notes were created. They allow investors to add money to a company and convert the debt into equity later on. This is obviously done with some special terms so that the investors do not lose what they add to the company.
Basically, convertible notes carry a unique characteristic among investments. One such special term and characteristic is that it has a maturity date. And since convertible notes are technically debt, if the note is held to maturity, the note holder can demand a payback. The maturity date is the deadline for a preferred round. In fact, only during a preferred round can the convertible notes convert into equity.
Let us assume that there is a maturity date 5 years from the date of investment in the company. If the company hasn’t had a preferred round within this time, the investor can demand their money bank. Although such cases don’t often occur, when time passes, a new deal is usually created. But it is a good thing to know that these terms exist. There are lots of other terms as well which would be explained more in detail.
Examples of convertible notes
Let us take different examples for each and understand better.
Convertible Note with both a discount and valuation cap
It is common for companies to issue the convertible note with a discount and valuation cap. For this, the investors look into the options and convert their debt into equity at the lowest possible rate to see what they would get and make their decision.
Let us assume that the company – Best Inc received $40,000 from an investor – Tony in exchange for a convertible note that has a 20% discount and $3M valuation cap to the Series A round. Now, let us fast forward and move to the time the company undergoes its Series A round. At this time, let us assume that the company is valued at $6M at the price of $6 per share.
In this case, the 20% discount on the share price will mean that Tony will have his investment converted at the rate of $4.8 per share. However, the valuation cap will result in $3 per share (3M/6M * 10) will be the actual price of the conversion for the investor.
Convertible note with only a discount
Let us assume that a company – XYZ Inc raised its first round of $50,000 from an investor – Tom in exchange for a convertible note with a 20% discount to the Series A round. During the Series A round, the company was valued at $10M with $10 per share price.
Since Tom was offered a convertible note that has a discount of 20% on the share price, when his debt converts to equity, the conversion will take place at the price of $8 per share. So, with this investment, he will get about 6250 shares (50,000/8) from his investment, which would have otherwise costed $62,500.
Convertible note with only a valuation cap
Let us assume that the company Best Services raised its seed funding of $60,000 from an investor – Zed in exchange for a convertible note that has a $6M valuation cap and no discount. When the company reaches its Series A round, it is valued at $12M at a price of $12 per share.
But even though the company has got the value of $12M, Zed would have the advantage where his investment will convert into shares at the valuation of $6M. So, he will get the share price of $6 (6M/12M*10) and it would convert his investment of $60,000 to 10,000 shares, which would have otherwise cost $120,000.
Benefits of Convertible Notes
With everything clear on what convertible notes are, it is time to talk about the various benefits that convertible notes offer entrepreneurs. Obviously, one main benefit is that the startups do not have to define an upfront value of their company and still get funding in exchange for offering these investors with equity in the future. But that is not all; here some other benefits of convertible notes:
- Convertible note financings are very easy to document from a legal perspective. This basically means that it is cheap to create and the rounds can be closed quickly as well. It is all because the investor and the company are putting off the trickier details for a later date. Additionally, unlike other financial rounds that need several documents like operating agreements, certificates of incorporation, and so on, convertible notes do not need such processes. And with this, the time and costs are heavily reduced.
- Raising a convertible note as opposed to equity allows the company to delay in getting a valuation done. It is a great thing for startups. Additionally, investors also get the option to get a discount on the future price of the shares later when the security matures, benefiting both the company and the investor. It is one of the reasons why convertible notes are used as the first outside funding invested in many companies.
- There are times where companies need to raise some amount of funding between the larger rounds of equity. And with convertible notes being an option, it becomes easier for them to do so. So, if a company needs some money instantly to have the deal sealed faster, using a convertible note is a good idea. This would also allow the company to delay the valuation decision for the equity round.
What is a cap in a convertible note?
The very first typical convertible note terms is the cap in a convertible note. The valuation cap is a hard cap on the conversion price for the note holders, regardless of the price per share on the next round of equity financing. However, if there are any automatic conversions that occur at the maturity date (if no qualified financing round has occurred) they are at some price per share much lower than the cap.
There are many other typical convertible note terms.
Convertible Note Terms
There are two other features of the convertible note other than the maturity date and the valuation cap. Each term is going to be explained below. But before we can get to that, you need to know that using these next two terms are not required, if you choose to ignore them in your deal. They just act as the negotiation levers. So, it is important that you know about them in case your investor asks you to add such terms in the deal.
Here are the four terms explained:
- Discount Rate: The convertible notes usually have a discount added to the terms, only if both the parties want it. In fact, the discount is a benefit for investors that value the shares issued in the subsequent financing round at a lower rate than what new investors are paying at a price per share. For instance, let’s say an investor gets a convertible note for $50,000 with a 20% discount rate. When the company has another financing round and issues the shares worth $10 to the new investor, the convertible note holder would be paying just $8 per share and would get a higher number of shares than they would have otherwise.
- Valuation Cap: As mentioned before, a valuation cap is a term of the convertible note that is required unlike the discount term. It is a protection for investors against being diluted in companies that have high-growth fund raising rounds.
For instance, let us say that an investor bought a convertible note worth $50,000 in your company with no valuation cap. In this case, during the next financing round, the company sees a huge amount of growth and gets a pre-money valuation of $10 million with 100,000 shares outstanding. With this valuation, the ownership percentage of the investor is very small, about 500 shares. Now, when the note has a valuation cap at $1 million, the investor would use the pre-money valuation of $1 million and get a lot more shares in the company, around 5,000 shares, which is much more than 500.
- Maturity Rate: For an investor to purchase debt that would turn into a tangible benefit, the debt must convert to equity. And there are two ways for this, one is through a maturity date. This is a functional backstop for investors, which guarantees that at some point they will have the option to convert their debt into equity even if the company does not undergo a qualified financing event. This date is determined at the time the note is created and it is normally for two to three years from the signing of the note. If the date passes, and the debt does not convert automatically, the investor can elect to have it converted or demand for the loan amount to be paid back.
- Interest Rate: This is just what it sounds like, but it is not a requirement for convertible notes. Everyone knows what interest rates are since it is the way lenders make money. But most of the time the interest rates for a convertible note is set at 0, as it is not important to gain profits from it.
Qualified Financing Event (QFE)
This is the one of the most common ways to have the conversion triggered. It is normally a set amount negotiated in the convertible note that sets a limit within the next equity financing round. If the money raised exceeds the QFE, the debt would convert into equity. The main idea is to first protect the investor and next to allow the company to gain a significant amount of cash in their equity round without having to deal with the complication of issuing additional shares.
Convertible Notes – How it works?
With all the above clear, let us now get to talking about how convertible notes work. It can be very difficult for entrepreneurs to get an idea of the long-term impact of a convertible note on their business. And the best way to look into this is by taking examples and talking about each kind of situation that might come up.
So, let us begin. Let us assume that there is a startup that raises about $100,000 convertible note with a maturity date of 3 years after the signing. And with this, the company receives a valuation of $2 million, or $1 per share, in one year. Let us take five different situations that can come up in this case as shared in the table as well:
|Cost of Funding
|Interest & Cap
|Discount & Cap
|Interest, Discount & Cap
Convertible note examples with different terms as shared in the table above include:
- Only interest – A convertible note that just has an interest rate functions a lot like short-term business financing.
- Only discount – The next most predictable convertible note is one with only a discount rate. Even though a discount rate is a little more expensive than the interest rate, it is much better since the entrepreneurs would not know the total cost until they get a valuation.
- Interest and cap – The valuation cap when included in the note, doubles the total cost of funding for entrepreneurs. This is because the note is converted at the valuation cap, instead of the actual valuation.
- Discount and cap – Having both the valuation cap and discount increases the cost by more than double since the calculation applies the discount rate after the valuation cap. This results in a greater discount per share for investors who convert and a higher overall cost for founders.
- Interest, discount, and cap – For the final example, the convertible notes with discount, interest and a valuation cap are the most expensive for the entrepreneurs.
Note: This is one example of how convertible notes can be calculated. An alternative calculation for convertible notes takes the higher discount after considering the effect of the discount rate and valuation cap from the company valuation, and not both together. We use this calculation on our convertible note calculator and round modeling at Eqvista.
With these examples clear, you now know how you need to negotiate when offering a convertible note. Try your best just to keep a valuation cap and a maturity date.
Pros and Cons of Convertible Notes
Just like everything else, there are benefits and disadvantages of a convertible note. Let us have a look at all the pros and cons.
Pros of a Convertible Note
- Deferred negotiations – Due to the use of a convertible note, the startup can easily defer to get its valuation to a later stage and can be valued higher. It saves both time and money.
- Investor benefits – Investors are safe with this as they act as debt holders and are then converted to equity holders later on when the risk of the company reduces. They also receive a lot of additional benefits like discounts or valuation caps to reward the risk they are taking.
- Few complications – Unlike the equity funding, the company does not have to be registered as an LLC or C corp to get funding with a convertible note. And the process has less paperwork and a lower legal fee.
Cons of a Convertible Note
- Lack of noteholder control – The investors are at the mercy of the startup owners and do not have much power to sway the outcome of their investment. They also do not have the power to negotiate on the future valuation of the company and end up with a valuation they do not agree to.
- Faulty clauses – Since the convertible notes are customized as per the deal, investors can end up adding many clauses that can have future implications on the growth of the company and the company.
- Future risks – If the valuation cap is low, it can affect the company negatively as the investors will be able to get a large portion of the firm’s equity at a low price. And if the valuation cap is high, the next round can affect the investors negatively.
- Future-decision making right – The investors who get the note get a future right to be a part of the decision making process as well. And if the investor gets a huge portion of shares, they can start interfering with the decision making process in the company causing issues.
Convertible Note Alternatives
Standard convertible notes aren’t the only options out there. Those businesses that are looking for funding in their initial stages can easily get it with other versions of convertible debts that have added flexibility and benefits. Here are some of the alternatives to traditional convertible note funding:
- SAFE: The SAFE (Simple Agreement for Future Equity) was developed by Y Combinator, and is used to capture the flexibility of convertible notes without the debt component. A SAFE does not have the typical convertible terms like interest rate or maturity date. Due to this, the agreement between startups and investors are much simpler. Additionally, the startups that use SAFEs for raising funds do so as it doesn’t place a time limit on the startup’s development.
- KISS: Keep It Simple Security, also known as KISS, is a lot like a convertible note but has a debt and an equity version. It holds some additional clauses and triggers related to the sale of the company, transfer of rights, and minimum funding rounds. And even though it might be a great option for a contract that spells out every scenario, entrepreneurs need to make sure that they understand the potential impact of each and every detail.
- SBA Microloans: While convertible notes are one of the most common ways for a startup company to get financing, SBA microloans are available for short-term funding of up to $50,000. The average SBA microloans are under $15,000, but there are many entrepreneurs out there who find this money far less costly than equity. In fact, a microloan can easily fund the early development stages of a company, which is what the main idea is all about.
- Grants: Entrepreneurs can easily apply for business grant opportunities from nonprofits, national, state and local governments.The sizes of grants vary and the qualification requirements depend on the mission and the location of the business and the entrepreneur’s background. This field is competitive, but so is raising money from angel investors. And that is why for many entrepreneurs, it’s worth a shot.
Convertible Note Calculator
There are times where the calculations of convertible notes into company shares can be highly confusing. And with many people not aware of the math involved, it becomes very stressful not to understand how to reach the final outcome (fully diluted cap table). That is where Eqvista comes in with its advanced convertible note calculator to help companies out there see how much ownership their convertible notes and shareholders offer. One of the tools that we use is round modeling. Let us understand this better with an example.
Let us say that you just started your company and have three different securities, being common shares, preference shares and options. Your company cap table looks as below:
Now, let us say that you have everything ready for your company but you need an initial investment for taking the first step and entering the market. You decide to take on $600,000 of funding through convertible notes.
The first investor gets a KISS note for offering you with $100,000, with a valuation cap value of $1 million and a discount rate of 10%. The second investor agrees to offer you a SAFE of $200,000, with a valuation cap of $2 million and a discount rate of 20%. The third investor agrees on offering you a $300,000 SAFE with a valuation cap of $2 million and a discount of 20%.
Here is the overview of the convertible notes in the company:
Note: We have excluded the interest rates in these notes for simplicity.
With this in hand, all you need to do is fill in the details for each convertible note on the Eqvista application. Once you fill in the details, it will be recorded and the calculations would be handled by the application on its own.
Next comes the part where you can now see how these convertible notes affect your company when the next financing round is taking place. Let us assume that the pre-money valuation of your company is set at $3 million before the next funding round. And setting aside a post-money option pool of 10% and a new investment round of $1,000,000, you will get the following results in the round modeling to help you see its effects in your company’s ownership and cap table.
This is how the overview of the financial modeling will look like on Eqvista:
From the above, you can see that the ownership amounts of the common shares, preferences shares and options change. Initially, the ownership of the common shares, preferred shares and options were at 52.63%, 26.32%, and 21.05% respectively. But after the new funding round came in, they have changed to 20.39%, 10.20% and 8.16% respectively, being diluted by the three convertible notes, new option pool and new investment round.
You will also be able to see how much ownership has been offered to the investors with the KISS and SAFEs convertible notes, which will be converted now as another funding round is about to take place. It will also help you get an idea of the value that your company has and how much control you still have over it.
From this, you can easily add in the values to the Eqvista app for each kind of shares or convertible notes offered, and the convertible note calculator in the application will take care of the rest. It will help you see much ownership % each of your convertible notes converts to for each series funding.
Convertible Note vs Equity – Which one is right for you?
Regardless of if you are an angel investor or an entrepreneur, the topic of convertible note vs equity impacts you. To begin with, startups prefer convertible notes and angels prefer equity. But which one is the best choice for your company? This has been explained below to help you understand the difference between each of them.
Convertible debt was initially used as a bridge between two funding rounds in a company. However, it has recently become highly popular as a seed round funding instrument.
For example, an angel investor invests $300,000 in a startup as a convertible note. The terms of the note are a 20% discount and automatic conversion after a qualified funding round of $1 million. With this clear, let us assume that the shares were priced at $1 and since the discount is 20%, the investor can now get a share at $0.80. This would give the person 250,000 shares for the price of $200,000, which is not bad. There are many other terms in a convertible note that affect how many future shares they get.
While convertible notes are confusing to calculate, equity is a breeze. The startup gets a pre-money valuation and the share price is determined. When you invest, you know exactly what the terms are and how many shares you will own at the end of the round unlike the situation that comes up with a convertible note. And that is why when people talk about convertible note vs equity, they find equity a great choice.
Let us take an example to understand this better. There is a startup that has a pre-money valuation of $1 million and has 1 million shares outstanding. This gives the value of $1 for each share. Now, an angel investor makes an investment of $300,000 and gets 300,000 shares in return. With this, the post-money valuation is now $1,300,000 and the new investor owns about 20% of the company of the company.
Why convertible debt?
With this explained, let us now understand why between convertible note and equity, convertible notes are better, even after equity is much easier to understand. Well, here are the four main reasons why:
- Valuation: Getting the valuation of a startup is very hard, mostly if the startup is in the idea phase. So, how exactly do you put a value on that? In such a case, it is easier for the startup to put off that question until the company has grown. And the best way to gain capital is through convertible note funding, which delays this issue.
- Speed: The valuation if done for equity can take long before it comes and then take weeks for the negotiation of terms and agreeing upon them. With debt, the terms are simpler and are usually dealt with later on. All that has to be done is the negotiation on the few terms like cap, interest, discount and so on, if these terms are needed in the contract.
- Cost: The term sheets for convertible notes are less expensive as compared to the term sheets for equity. So, it does not make any sense to pay the additional legal costs for closing an equity round if the funding increase is less than $250,000. This just makes convertible notes much easier to use.
- Control: When a startup raises debt, the majority of voting stock remains in the company with the founders. This means that when there is a decision that needs a vote, the founders will have more control over the company. With equity, the situation is not the same. The shareholder gets a huge part of the company along with a control of it as well.
We are not saying the equity route is a bad choice; but every situation calls for a different kind of funding option. It is important that the one you choose benefits you in the right way. For this, you need to look at the pros and cons of each type based on your situation. And if you are a startup, the best bet you have are convertible notes. Both you and the investor can easily benefit from this.
Issue Convertible Notes on Eqvista
Eqvista allows you to create convertible notes easily and issue them out to the investors. Along with managing all the shares in your company, you can also issue and manage all the convertible debts and securities in your company through Eqvista. The process is very simple.
Step 1: If you are not already on Eqvista, you can create a free account and company profile here. Once you have done this, you will reach the main dashboard. Go to the sidebar and click on “Securities” and then on “Convertible Instruments”. You will reach the following page where you can see all the convertible notes you have in your company. And if your company is just a startup and this is your first convertible note issuance, click on “issue instrument”.
Step 2: You will reach the page where you need to issue and set up a Convertible note by adding the details as shown below.
You will need to add in the following details:
- Instrument Holder – The investor who is being issued the convertible note. If you have not yet added the shareholder, check out the article here on how to add one.
- Convertible Note Name
- Issue Date
- Note Type
- Principal – The original amount that the company borrows.
- Interest Rate (if applicable) – Rate on the principal amount that is accrued
- Maturity Date – The date when the payment has to be made back to the convertible 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 filled in, click on “Submit” and the convertible note will be created and issued to the investor. You will then reach the following page.
And just like this you can easily issue convertible notes using Eqvista.
Looking to record your convertible notes?
All in all, convertible notes are a great way to obtain funding from an investor without having to make any major decisions about your company’s equity at the initial stages. Once your company has reached a good place and is entering another equity round, that is when you can pay off the investor for the convertible note offered. It benefits both the company and the investor.
In case you want to use the other kinds of convertible security, you can. Just remember to keep a track of all the shares in your company. And the best way to do that is by using a great cap table app. Eqvista supports all kinds of convertible securities and every other feature you need to keep your cap table in order.