Getting capital for your new business is one of your most important tasks as a business owner. Whether you choose to go with debt, equity or a mix can have an effect on your company for months or even years to come.
With a convertible note, you have the opportunity to take on short-term debt that converts to equity. This type of funding is common for startups in the early stages of development and can give you the seed money you need to get your business off the ground.
It’s not the best fit for every business owner, though, so it’s important to know how a convertible note works and how it compares to other financing options.
What is a convertible note?
A convertible note is a form of short-term debt that can ultimately be converted into equity for the lender, typically an angel investor or venture capital firm.
A convertible note is typically used as the first round of funding for a startup. Instead of asking for the money to be paid back with interest, investors opt instead to receive ownership in the company, often in the form of preferred stock.
As a business owner, there are several benefits and drawbacks of using a convertible note to get seed money for your startup.
Pros
- You can delay getting a valuation until there’s more information to value your startup.
- You can complete the process within a few days, compared with issuing preferred stock directly, which can take weeks.
- You can avoid giving investors the same level of control they’d get if you issue preferred stock directly.
Cons
- You may have a hard time finding investors, especially ones who want to avoid losing control rights through a convertible note.
- If things don’t go as planned, the investor may call the debt and require payment instead of converting it to equity.
- It can be more complicated than just borrowing money through a traditional small business lender.
Comparing a convertible note with other options
There’s no right way to raise money for your business, and a convertible note is just as valid an option as other avenues. To make sure it’s right for you and your startup, though, here’s how it compares to pure equity and debt options.
Convertible note vs. equity financing
A convertible note starts out as debt then is converted to equity at a later time. This conversion typically occurs automatically when you close your Series A financing round.
Convertible notes are usually exchanged with preferred stock based on the terms of the notes, although these preferred stockholders don’t have the same control rights regarding board seats and veto rights.
In contrast, straight equity financing entails trading investment money for ownership in the startup, typically with some form of control.
In some cases, convertible notes can be preferable to equity financing because while you’re giving away ownership, it doesn’t come with the same control rights as issuing preferred or common stock directly.
On the flip side, if things don’t go as planned, a convertible note is still a debt, and the noteholder can demand repayment. With equity financing, an investor may stand to lose their investment money, but you don’t need to repay anything.
Also, keep in mind that convertible notes are typically only used in the early stages of a startup, whereas you can rely on equity financing at every stage of your business’ life cycle.
Convertible note vs. debt financing
A convertible note is technically considered a loan, at least until it isn’t. If everything goes as planned, your notes will be converted into equity, and you don’t have to worry about paying back the debt.
With debt financing, on the other hand, you’re borrowing money from a lender — usually not an individual but sometimes it can be — you’ll typically need to start repaying the loan or line of credit immediately.
When choosing between the two options, a convertible note is only worth considering if you have plans to raise money through venture financing. If you don’t, you’ll likely have a hard time finding anyone who wants to invest.
That said, while you won’t be giving up control rights through convertible notes, you’re still giving up ownership. If you want to preserve your ownership stake, debt financing may be a preferable option.
Typical convertible note terms
There are a few components of a convertible note that make up the terms you’ll offer to investors, including the discount rate, valuation cap, interest rate and maturity date:
- Discount rate: This represents the valuation discount you give investors who purchase convertible notes relative to the valuation used as a base for investors in subsequent financing rounds. Essentially, a discount rate provides compensation for the added risk you’re taking by investing early.
- Valuation cap: This is a cap on the price at which your notes will convert into equity for your noteholders. For example, if the cap is $5 million and your Series A valuation is $10 million, notes may convert based on the $5 million figure.
- Interest rate: Because it’s a debt instrument, there’s an interest rate attached that accrues and increases the number of shares the investor receives at conversion. Also, if the investor calls the debt instead, it’s the cost of the debt you’ll need to repay along with the principal amount.
- Maturity date: The date at which the convertible note is due, and you’ll need to either repay the debt or convert the note. Investors may have the right to extend this date, possibly in exchange for a renegotiation of the note’s terms.
To give you an example, let’s say you issue $500,000 worth of convertible notes with a 20% discount and a $5 million valuation cap. Then when you raise money with a Series A round, it’s with a $10 million valuation and a share price of $5.
When determining the conversion price, investors claim the better value between the discount rate and the valuation cap.
So in this scenario, the discount rate gives your investors a share price of $4, or 20% of $5. If you apply the valuation cap, the share price is $2.50, or $5 multiplied by the percentage of the cap relative to the series valuation — in this case, 50%.
Between the two, the valuation cap provides a better conversion price, and you’ll convert the $500,000 worth of notes into 200,000 shares of preferred stock.
Of course, this is a simplified example. If you were to issue $500,000 in convertible notes to multiple investors, it’s possible to have varying terms, which means different investors may have different conversion prices for their notes.
When it’s worth considering using convertible notes
As mentioned previously, convertible notes are worth considering only when you have plans and reasonable assumption that you can raise venture capital funding through series rounds. If doing so is unlikely, you’ll be hard-pressed to find investors willing to take a chance on your convertible notes.
But just because your startup is on its way to a Series A financing round, that doesn’t mean using convertible notes for seed money is your best option.
As with any other financing option, it’s important to compare all of your options and pick the one that’s the best fit for your startup.
More specifically, consider the ways a convertible note is structured can affect your business. If everything goes as planned, you can take on debt without ever having to pay it back — at least not directly. And instead of exchanging investments for ownership with control rights, you’re giving investors preferred stock while retaining control.
Convertible notes are especially valuable if you need to raise a significant amount of money but want to delay a real valuation until later when more information is available to get an exact figure.
But if you want to avoid giving away more ownership than is necessary at your Series A round, it may be better to rely on debt financing than convertible notes that convert to equity.
The bottom line
Convertible notes can be a beneficial way for small business owners to get seed financing for their startups. But before you start the process of looking for investors and preparing a promissory note, take some time to research all of your financing options to pick the best one for you.
That can include small business loans, angel investors and alternative financing options. As you compare each option, along with its benefits and drawbacks, you’ll have a better idea of what’s best for your company now and in the future.
This article was originally written on August 20, 2019 and updated on August 21, 2019.
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