Startup Financing – Why Convertible Notes For Early Stage Funding
Ready to raise funds, but not ready to commit to a formal valuation of the company? Convertible notes might be your answer. Convertible notes are one of the most common ways investors invest money in early-stage startups, and yet, they can be very confusing. Here are the key points on that you need to know about convertible notes while raising your first round of funding.
What is a convertible note (aka Convertible Debt)?
A convertible note is a short-term loan from investors for early stage startups that later on converts into equity; it is a hybrid of debt and equity.
In plain words, investors loan money to a startup as its first round of funding; and then rather than get their money back with interest, the investors receive equity in return.
Typical terms on convertible notes:
Interest: As the nature of debt, the invested funds for a convertible note earns a rate of interest, and the interest can be either simple or a compounded rate based on principle.
Maturity Date: It is when the notes are due and payable to the investors if they have not already converted to equity.
Pros – Why you want to do convertible note financing
- Simple, fast and cheap.
Because of the deal terms, convertible note financings tend to be faster, simpler, and cheaper than priced rounds.
- Full control.
You are not selling part of the company, you remain full control of your company.
Cons – Why convertible notes may not work for you
- Time is ticking on convertible notes.
Every month, the interests on the convertible notes are accruing, hence your liability number is getting bigger.
When does it convert?
Conversion happens at a specified point, usually during a new valuation with a new funding round.
Do you have to pay it back? (after all it is a debt)
Good but pretty complicated question! The answer is something like “theoretically yes, but probably won’t have to.” Investors know the real possibility that they might lose their investment and are usually pretty flexible and cooperative when there are opportunities to have a better return and make a better outcome. Be aware of what can happen if your company does not have the ability to pay it back, always be prepared and think steps ahead.
Tie to accounting:
How do you record the convertible notes in your accounting books you may ask? In your accounting books (ie. QuickBooks Online), record the original loan amount (principle) and monthly interests as short-term liabilities in your balance sheet. At the conversion event, convert the original loan amount, as well as the accumulated interests into preferred shares when the conversion happens.
Takeaway:
When it comes to using convertible notes as a seed investment, founders need to know both sides of the situation. You need to know what happens if you do not end up raising an equity round of financing, and also what happens if things go spectacularly well and you are able to raise additional equity far above the valuation cap.
Convertible note is a complicated concept, we strongly recommend talking to an attorney before making any fund-raising decisions. The book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld is a great resource as well. Good luck raising funds! May the force be with you!
