When getting your startup off the ground, raising capital can feel like a full-time job. That’s why it’s so important to understand the options you have when it comes to finding funding. A common question we hear from our countless startup clients across the globe is “What Are Convertible Notes?”
Our Short Answer:
A Convertible Note is a form of short-term debt that converts into equity. It’s one of the most commonly used tools used by a startup in raising money during its first round of financing. These are commonly used by startups who wish to delay establishing a valuation for that startup until a later round of funding or milestone.
Convertible notes are structured as loans with the intention of converting to equity. The outstanding balance of the loan is automatically converted to equity at a specific milestone, often at the valuation of a later funding round.
Why should my startup use Convertible Notes?
Convertible Notes are the best option for a Startup because they defer having to put a valuation on the company. It’s nearly impossible to put a valuation on an early stage company, especially in situations where the company is still just an idea, making it the best option for a new concept or business. Notes offer a simple, cost-efficient, and fast way for startups to obtain funding as compared to traditional priced equity rounds.
There are four basic components to a Convertible Note. The two most important ones, in general, are the valuation cap (or “cap”) and the conversion discount (or “discount”). Let’s run through them:
1. Valuation Cap
A valuation cap sets the maximum valuation at which the investment made via the convertible note can convert into equity. Investors in the convertible note typically get converted at the lesser of the valuation of the next qualified priced round and the cap. On the East Coast, around 3 to 6 million dollars is a typical cap in the first round of financing, and 5 million is usually the average. A suggestion is to always start higher at a 6 million cap with the expectation to negotiate down to a lower amount.
2. Discount
This refers to the discount that will be applied to the price per share in the qualified financing, usually between 15% to 30%, with 20% being the most common discount offered. A discount in a note sets a percentage reduction at which the convertible note will convert relative to the next qualified priced round. This permits an investor to convert the principal amount of their loan (plus any accrued interest) into shares of stock at a discount to the purchase price paid by investors in that round.
3. Interest Rate
The interest rate of a convertible note indicates how much interest accrues to the investor prior to the note’s conversion to equity or its repayment as cash when called. Convertible Notes will more often than not accumulate interest. The interest rate usually falls between 4 to 8% on the east coast with 5% being the most common, and between 2 to 4% on the West Coast. Note that interest rates cannot be lower than 2% or they might not be viewed as a convertible debt instrument.
4. Maturity Date
The maturity date of a note indicates the date when the note is due to be repaid to the investor along with any accrued interest if it has not yet converted to equity. This usually falls anywhere between 12 and 24 months. The most common date of maturity is around 18 months, but we always aim to get around 24 months. In most situations, startup investors will not call for a note to be repaid at the maturity date, and will instead amend the note to extend the note’s maturity date, typically for another year. There are some convertible notes that call for automatic conversion to equity at maturity date at a pre-defined price, but these are unusual.
Bottom Line:
If you’re trying to raise money, a Convertible Note is probably the best way to start if it’s your first round of financing.
If you still have questions on this topic, reaching out to a lawyer for advice is recommended. At Benemerito Attorneys at Law, we offer free consultations and would love to help guide you toward the right decision for your business.
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This blog is for informative purposes only. This information does not constitute legal advice. You should consult with a licensed attorney that can advise you according to your particular circumstances.
