5 pros and cons of convertible notes

Issuing shares is a common practice for companies to raise capital. This works well for companies that have built a reputation strong enough to convince investors. But for startups, despite issuing shares, there might not be enough takers. This is where convertible notes are useful. Let us first understand what convertible notes are.

Convertible notes

Startups are typically cash strapped and as they do not have sufficient cash in hand, they compensate by offering equity in the company. This is the case even in startup recruitments where it is common practice to compensate salary components with equity. Similarly, to raise funds, startups offer equity to investors. But there are different stages in this process. Once a company has crossed the private investment stage, the first external funding is usually sought using convertible notes.

What are convertible notes?

A convertible note is an investment vehicle through which an investor loans money to a startup and in return receives equity in the company. Convertible notes differ from a regular loan in the fact that in case of a regular loan, the company will owe the investor the principal amount along with accrued interest. Whereas convertible note issuances are designed to be converted into equity to the extent that any outstanding balance will also be automatically converted to equity at a particular milestone event such as valuation for a later funding round.

Convertible notes are a convenient method of raising capital, especially for startups because issuing them does not require company valuation. This works perfectly for startups as in the initial stages, a startup is just an idea. Hence, seed funding using convertible notes is quite a convenient option. Neither the issuer nor the investor is forced to determine the value of the business at the initial stages, when there is nothing much to base the valuation on. However, convertible note terms form a strong foundation for later-stage funding rounds based on actual company valuations.

Convertible note templates can be of different types based on investor requirements. But some important aspects define convertible notes. The four basic terms used to understand the workings of convertible notes are:

• Discount rate – From an investor’s point of view, it is a risk to invest in early-stage companies. The startup could do well or fail, placing all investments at risk. Hence, a discount rate is a valuation discount offered only to those early-stage investors bearing the risk of investing in convertible notes. This discount rate is not offered to investors of subsequent financing rounds.
• Valuation cap – This feature caps the price at which the investor’s notes will convert into equity. This is a unique and added advantage of investing in convertible notes. It provides the investors with ownership rights similar to equity holders and comes in handy in case the company dissolves abruptly.
• Interest rate – Convertible notes are ultimately loans and will accrue interests. But for an investor, instead of receiving interest returns in cash, the total investment (principal amount plus interest accrued) increases, which in turn translates into an increased number of shares that will be issued upon conversion.
• Maturity date – This date is set during convertible note issuance. It is the date on which the note is due for conversion and the company has to repay the investor with converted equity.

Convertible note templates can be created with a combination of various factors, however both the issuer and the investor must agree on the terms in the early stages of negotiations owing to the unpredictable nature of startup operations. This helps avoid unnecessary legal hassles at later stages.

How do convertible notes work?

As discussed earlier, the basis of convertible note issuance is the conversion of the investments to equity. But the working of this principle changes based on the variation of these three basic aspects: valuation cap, interest rate, and discount rate. Let us look at some combinations of these factors:

• Only interest rate – If only an interest rate is applied to the investment, it functions as a regular business loan.
• Only discount rate – Offering only a discount rate on the investment is the next most reliable option for investors. It is advantageous for the company as well since they will not know the total cost until an actual valuation.
• Interest and cap – With this option, the note is converted at a valuation cap instead of the actual value. Besides, interest will accrue on the principal amount. Together this almost doubles the total cost of funding for the company.
• Discount and cap – Applying a valuation cap in addition to a discount rate ultimately results in an increased discount per share for the investor. This increases the cost of funding for the company by more than double as the calculation applies the discount rate after a valuation cap.
• Interest, discount, and cap – This is the most expensive option for company founders. Convertible notes issuances involve applying an interest rate, discount rate as well as valuation cap.

Let us look at an example where all these options are at work. Imagine that a startup has raised a $100,000 convertible note with a maturity date of 3 years. Further, the company receives a valuation of $200,000, or $1 per share, in one year. The table below lays out the various workings of convertible note:

Note: This is one way of calculating the effects of these terms on convertible notes. An alternative way of doing it is to consider the higher discount after observing the effect of the discount rate and valuation cap from the company valuation, instead of considering both together.

5 important pros and cons of convertible notes

Convertible notes though a commonly used seed-stage funding option have downsides as well. It is the investor’s call to calculate the risks before betting their money on a startup using notes. Let us look at some pros and cons of convertible notes:

Pros of convertible notes

• Low risk and efficient – Convertible note terms do not technically sell actual share ownership. For all practical purposes, it is still a loan. So both the issuer and the investor can skip the risk of incorrect company valuation, thus preventing tax implications as well. This works perfectly for startups as valuation is difficult in the initial stages.
• Pre-valuation investment – Convertible note issuance is usually the first external funding sought by startups. Since it does not require company valuation at this stage, it allows the business to sail through to the next stage of funding rounds. By this time, the company would have created fair value with sustained efforts over a considerable period. Advanced metrics can then be used to evaluate the company’s worth at these stages.
• Fixed income for noteholders – Since convertible notes are loans, by the principle of interest rates and valuation cap, investors holding these notes are assured of a fixed income. Though all of these will translate into equity, an assurance on the invested amount is beneficial for investors. Besides, more operating income is made available for the common shareholders who invest at a comparatively higher price per share. Convertible note terms thus ensure profitability for the issuer as well as the investor.
• Voting power – Unlike common shareholders, investors with convertible notes do not have voting rights on corporate affairs. Thus, if the management is worrying about losing voting control during discussions about alternate financing options, convertible notes come in handy.
• Simpler documentation – Since company valuation is parked for a later stage funding process, from a legal perspective as well as economically, documentation for convertible note issuance is simpler. The funding round can be quickly closed as well. Otherwise, equity rounds require the company to produce various documents such as the certificate of incorporation, operating agreements, shareholder agreements, etc.

Cons of convertible notes

• Absence of control in the company – A typical investor is usually a common shareholder who purchases equity after careful evaluation of the company’s performance, enjoys a sense of security about their return, and have voting rights in crucial business matters. This is not the case with convertible note terms. For new investors investing in a startup for the first time, it is difficult to gauge if the terms of the note are fair. Besides, they will not have any say in the company matters as well.
• Ambiguity – Since convertible note investment is done mostly with startups, a common risk investors face is the failure of repayment. If the startup cannot raise subsequent equity financing, the business will not have sufficient capital to repay loans. Also, all notes don’t need to include clauses for automatic conversion on maturity. To avoid any such unpleasant situations, it is advisable for investors to address all terms of the agreement including conversion clauses and lay them out on a convertible note certificate.
• Risk of Bankruptcy – While on one hand, company evaluation is needless for convertible note issuance, the absence of this places investors at high risk in comparison to common shareholders who have hard evidence backing their investment choices. Further, shorter the maturity period, greater the risk.
• Stringent indenture provisions – Indenture provisions on convertible notes are generally much more stringent as compared to the ones levied on short-term credit agreements or the ones for common or preferred stockholders. Companies may be subject to a lot of disturbing restrictions under a long-term debt arrangement. These can be avoided with loans borrowed on a short-term basis or if they had issued common or preferred stock.
• Heavy debt – During times of financial crisis, it is extremely difficult to raise capital. In this situation, it is only natural for investors to extend their support based on secured loans. Since convertible notes do not provide this assurance, startups may find themselves in a tricky situation, either enticing new bondholders or being answerable to the existing ones.

Want to issue convertible notes?

With the option of convertible notes, we know that issuing shares are not the only fundraising option for companies. Eqvista is a one-stop unified platform where in addition to issuing common shares, convertible notes can also be easily issued to investors.

Eqvista’s convenient user interface enables entrepreneurs and founders to issue and manage investment instruments with ease. Convertible notes can be easily issued and modified in 6 simple steps. For any questions, reach us today!