A convertible note is a popular way for investors to invest in a business that is in its formative stages. It is basically structured as a loan, the only difference being that it converts into equity after the business becomes more established i.e. acquires more funding or reaches a particular milestone.
We’re going to go over the details below, but if you’re still confused feel free to check out– experienced attorneys will answer your questions about convertible notes amount other legal topics on demand.
How it works
Convertible notes are mostly used for seed rounds (the first investment capital received by a startup). Deciding how much the company is worth is difficult in the early stages. Convertible notes defer valuation to a later point in time when it is easier to do so. The number of shares you have been allocated is determined during the next round of financing i.e. Series A. At this point, the company will have a somewhat decent operating history that other venture capitalists or angels can use to calculate a fair price.
In a bid to indemnify the seed investors for the added risk of investing in the preliminary stages, convertible notes often have extra clauses, such as discounts, and or caps.
Listed below are some of the material terms & parameters that you should be on he lookout for:
#1. Class of Security
What will the note be convertible into? Preferred stock or ordinary stock? Consider the rights, privileges and preferences of each category of securities.
A convertible note is essentially meant to be converted at some point in the future, not for it to stay pending indefinitely.
*Expiration of Maturity Date:
At this point, the note-holder basically seeks to convert the outstanding amount. He could also choose to ask for his money back (although this rarely happens). Usually, this time period is no shorter than a year and could be as long as 2 years. Some companies however reserve the right to extend the maturity date for an additional 6 to 12 months.
*Change in control upon a change of control event in the future occurring before the convertible is converted. Investors may choose to ask for a multiple of their loan back as payment instead of converting to ordinary shares before the finalization of the change of control event.
#3.The interest rate on a note
Being a form of debt or loan, a convertible note usually accumulates interest for the time period between when you sign it and when it converts. The rate is usually between 4-8% and is converted as part of overall amount during the next round. For instance, if your annual interest rate is 5% and you hold a Loan Note of 100, then you’d convert to 105 at the end of the year.
Will the convertible note be secured? If so, which one of the startup’s assets are being used as collateral?
Warrants are another form of incentive to the investor. “Warrant coverage” by definition refers to how large the warrant is (how many shares), expressed as a percentage of the principal amount of the convertible note. The warrant enables the investor to buy extra shares of the category and series of shares in the Qualified Round.
#6. Valuation Cap
This is another way of rewarding seed investors for the additional risk that they take on. The valuation cap puts in place the maximum price that your loan will convert into equity. For example, if one invests $3 million into the business, and the Series A investors value the business at $6 million and pay $1.00 per share, the convertible note changes into equity as if the price had been $3 million. This translates into an operative price of $0.50 per share which means that, for the same price, the investor acquires twice as many shares as the Series A investors.
Convertible notes typically convert using either the the discount rate or the valuation cap, whichever gives the investor a better price.
#7. Discount Rate
It calculates how much compensation is owed to you for the extra risk you’re taking on by investing in a company before the series A investors. For example, if your convertible note has 30% discount rate, and the A round investors end up investing at a price of $1 per share, your note will convert into equity at $0.70/share.
#8. Next Equity Financing.
The next round needs to be defined (i.e.,number, class of security to be sold, etc.). Conversion is usually automatic, but at a discount to the amount paid by the new investor. The discount figure can be as high as 50%, but averages somewhere between 15-30%.
#9. No Next Financing
If conversion is permitted, and you happen to fail to raise the Next Equity Financing. Can certain note-holders compel the others to convert? When would that option be enforceable?
Convertible notes have been touted as a “best of both worlds” deal; both a startup’s perspective as well as from the investor’s perspective. They not only protect investors but also the businesses as well ( No one would want their business to be valued at less than what it is actually worth). One thing is for certain though; convertible notes offer a fast, simple, and inexpensive method for startup funding in comparison to traditional priced equity rounds.
I hope this article helps as you decide what’s best for you. If you’re looking for affordable legal services to assist with your raise, feel free to check out.