A convertible note is a debt instrument that companies utilize to raise initial or “seed” funding. It is a popular way for investors to invest in a business that is in its formative stages. A convertible note is structured similar to a loan, the only difference being that it converts into equity after the business becomes more established either by acquiring more funding or reaching a particular milestone.
Convertible notes were pioneered to allow founders to get a quick loan from private investors in exchange for promising to repay those investors with stock at a later time when the price could be determined - normally, after a Series A funding round. 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 by allowing them to be valued more than their present value. One thing is for certain though; convertible notes are complex and should be drafted with the guidance of an experienced financing attorney.
There are other options for companies - such as equity financing - and a lawyer can assess if a convertible note or equity raise is right for your business better.
An attorney to turn to
With things like fundraising, it’s convenient and efficient to use the same attorney throughout. It’s smart to introduce an attorney to the process at an early stage such as the issuance of a convertible note.
Learn about useful terms
An experienced lawyer has assisted startups with this process already and can suggest terms that have worked in the past.
What’s the difference between a convertible note and an ordinary loan?
What distinguishes a convertible debt note from an ordinary loan are two key characteristics: (1) the discount, and (2) valuation cap. The discount is a feature that rewards early investors for taking larger risks than later investors. It does this by offering them the right to obtain shares at a cheaper price than that paid by Series A investors, once that round closes. The conversion cap similarly rewards early investors for their disproportionate risk, but in a different way than the discount. The cap sets the maximum value of a company when Series A closes, again giving an advantage to earlier investors.
Who are the types of investors interested in convertible notes?
Common investors include friends and family, angel investors, venture capitalists (VCs), crowdfunding websites, peer-to-peer lenders, and institutional lenders.
What happens to convertible notes if a company is acquired before the notes mature or are converted in an equity financing round?
The most common scenarios are: (1) the note gets repaid at a premium (principal + interest + premium); (2) the note gets repaid as an ordinary loan (principal + interest); or (3) the note converts according to its terms. A financing attorney can provide keen insight regarding which structure is most advantageous for your particular situation.
What are some material terms and parameters to include in a convertible note?
It’s common for the following terms to be included in a convertible note: 1) class of security (what the note will convert into); 2) conversion triggers; 3) the interest rate on the note; 4) whether the note will be secured; 5) warrants (gives the holder the right to purchase a company’s stock in the future at a per share price that is typically set at the time the warrant is issued); 6) valuation cap; 7) discount rate; and 8) the next equity financing.
What is the Qualified Round?
A Qualified Round is an equity deal that triggers conversion of the convertible note. There is usually a minimum amount of proceeds that need to be raised in the next round of financing in order for the investor's note to be eligible for conversion.
What does a “Most Favored Nation” clause in a convertible note mean?
A most favored nation clause (also referred to as a “MFN clause”) allows the convertible note holder to elect more favorable terms that are offered to any subsequent investors following the original investor’s investment and prior to a next equity round.
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