So you’ve got this mind-blowing startup idea. Now you need to convince someone to invest in your venture. Luckily, there are tried-and-true tools that will help you secure your very first funding. One of them is a convertible note. This tool is particularly helpful for idea-stage startups. They haven’t yet started their operations, so they can’t know how much money their idea will make. In other words, they need to use a slightly different approach to attract investors.
Let’s see how a convertible note works in practice.
What is a Convertible Note?
A convertible note is a type of investment that sits between borrowing and equity. But how so? First of all, it provides funding for your startup. In return, the investor—known as the “noteholder”—obtains the right to decide how to deal with the note at a certain moment in the future. That moment is called the “maturity date,” and it usually occurs 12 to 24 months after you issue the note. When your startup reaches the maturity date, the noteholder has the following two options to choose from:
- Money return. The noteholder may choose to get their money back. They also receive their interest on top of this, which is usually between 2% and 8%.
- Conversion into shares. The noteholder may prefer to convert their note into shares with a slightly better deal than your other, future investors. This is their reward for supporting your startup at its riskiest time.
While money return is a simple and obvious option, conversion into shares requires some further exploration. Let’s look at a couple of related concepts.
How a Convertible Note Defines Conversion Terms
Investors often recognize an opportunity when a startup is showing promise. So, they may prefer to stick to the company by acquiring its shares instead of seeking a financial return. This will be your victory, as it means your investors are confident in your startup and support it.
Now let’s see in detail how the convertible note can actually be converted.
When negotiating the terms of the convertible note, you should agree on the details for two conversion tools: a discount and a valuation cap.
- Discount: A discount stands for a reduction in the price per share. It enables the noteholder to get their shares at a 15–40% lower price than other investors.
- Valuation cap: This is a “ceiling” value at which the convertible note may be converted into equity. It has nothing to do with the actual valuation your startup will receive later during financing rounds. You and the noteholder use the valuation cap in calculations with each other and no one else.
The main aim of the valuation cap is to protect the noteholder. Otherwise, when you secure big funding in the future, that initial early-bird investment would look tiny and too risky.
For instance, imagine you attract $500,000 with a convertible note and you’ve agreed on a $5 million cap. That means that on the convertible note’s maturity date, the cost of your startup for the noteholder won’t exceed $5 million. Even if the startup realistically costs much more—say $50 million—for the noteholder, it will be the same amount as was specified as a valuation cap: $5 million. The noteholder will convert their note into shares as if the entire company’s value was $5 million—getting more shares for their investment. In our example, this makes a x10 return on the noteholder’s investment, which actually means that the valuation cap was set too low.
When the maturity date is reached, the noteholder has to choose between a discount and a valuation cap. It can only be one option and never a combination. The noteholder will naturally choose the option that works out as a better deal.
As you see, both tools—the cap and discount—protect the noteholder and help you to make them an attractive offer. You’re only starting out after all, and you really need your first investment. But here’s the thing: you also need to protect your interests right from the start. How? Keep reading our blog to learn about the potential risks a convertible note may hold.
Bottom Line
When you’re starting a company, you need to find ways to attract investors. A convertible note is one such way. You get the money you need to keep your business rolling, and the investor gets higher privileges than other investors.
Want to learn more about the basics of investment deals? At the Softeq Venture Studio, we explain startup lingo to participants and demonstrate how these terms work in real life.
