Convertible Notes are easy and fun to execute. Essentially, a convertible note is a debt instrument that converts to equity up the next equity round. So, although it looks like a loan, the intent is that it will become an equity position in the future, and investors treat is as such. They are a few simple terms that you need to understand to use an convertible note:
- Interest Rate – ranging between 5% and 25%, typically 8% simple interest
- Discount Rate – ranging from 0% to 30%, typically 20% discount to the next qualified financing.
- Term – the maturity date of the Note, which ranges from 1 to 3 years, typically 18 to 24 months.
- Valuation Cap – defines the maximum valuation upon which the note will convert to equity.
- In the event of liquidation – in the event the company is acquired (changes control) before the Note is converted to equity, typically the investors gets 2x their money back.
Reasons to use a Convertible Note
- Cheap, fast, and easy to implement
- Does not generate a K-1 if the company is an LLC
- Avoids haggling over valuation
- Templates available from multiple sources
- Commonly used, all startups, investors, and lawyers (the ones worth their salt) know how to use them
- Realize instant appreciation of between 20% and 30% of your value when the company converts your debt, your discount, and your interest into the new security.
- One of the few vehicles that includes “downside” protection. If a company raises capital at a lower valuation, you automatically benefit from the discount to that share price.
Reasons not to use a Convertible Note
- Typically does not include a board seat, authority, or oversight of Management.
- Does not have voting rights in matters that come before the shareholders.
- Companies use these as a crutch to move between valuation milestones.
- Too much convertible debt on the company’s books will stall or stop further investing.
Things you need to know about using a Convertible Note
- The highest and best use of the Convertible Note is for a true bridge round to help a company meet a reachable milestone that will increase its valuation.
- Startups use Convertible Notes to avoid haggling over the enterprise valuation of their company. That is good and bad. Companies should be realistic about their value and should be planning a priced equity round within 12 months before you should be inclined to invest in a Note.
- You should set the valuation cap at a value that is roughly where you expect the company valuation to be at the next priced round. If you price it too low, it will affect the valuation of the next equity round negatively. If you price it too high, you leave value on the table.
When you should use the Convertible Note
If you think the company is raising no more than $500k, has no more that $500k in long term liabilities with a strong outlook on revenue, and will have a significant equity round in three to six months, then the Convertible Note is appropriate.
For More information please see these other references and feel free to download the templates that are attached:
- Startup Lawyer
- Wilmderding – GREAT RESOURCE FOR UNDERSTANDING TERMS AND TERM SHEETS
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