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What is a Convertible Note?

A convertible note is a loan given to an early-stage company that will be paid back as equity once the company becomes more mature. This is an attractive option when it’s too early in development to put a valuation on a startup, and convertible notes have become a reliable source of Seed Funding for founders.  Investors forgo the interest they’d make from a traditional loan, instead, the loan would transfer into equity in the company and these shares are distributed during the following Series A financing round.

 

The Advantages of a Convertible Note Debt Financing

Early-stage founders find many advantages when financing through a convertible note.  Since they are not yet shares in the company, founders can avoid diluting any ownership or value while still getting the capital they need to grow.  Investors issuing convertible notes are not usually granted control rights or any seats on the Board of Directors – unlike investors with preferred stock – allowing founders to avoid outside influence on the direction of the company.  And since there isn’t yet enough data to create a uniform valuation, different investors can offer notes at terms, which gives founders greater flexibility in making deals.

 

Convertible Note Term Sheet

A convertible note term sheet outlines the agreed upon terms of the loan. Though it isn’t a binding agreement, it’s often used a tool during discussions around the deal.  Common terms associated with a convertible note term sheet include:

  • Discount rate: Investors are taking a chance on startups that don’t have a clear evaluation. Because of this, there should be some sort of discount in place for earlier investors.
  • Convertible note cap: Because you aren’t sure how the valuation will shake out, later on, you should put a cap in place for the conversion rate.
  • Maturity date: Investors will require a clear date when the loan will be returned.
  • Interest: While this is not a traditional loan that requires principal and interest, interest is typically applied to the overall equity amount that the investor will receive later.
  • Sale of the company: Most companies don’t sell before the convertible note maturity, something should still be put in place just in case this was to occur.

 

Consult a Startup Lawyer

LawTrades is always happy to connect clients with the best attorney for their situation. Our highly skilled and experienced startup lawyers can help you with all things business-related, including convertible notes and other types of fundraising. Because businesses usually need ongoing legal help, you may also be interested in selecting one of our subscription-based legal plans. Please contact us today for more information.  

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