Growing a startup into a successful business requires more than blood, sweat, and tears. Most ventures need capital to realize their full potential. Unless you have a hefty savings account, you’ll need external funding.
But often, investors aren’t willing to place their bets on a startup that has no valuation or guarantee of return.
The good news: There’s a way to get the financial backing needed to scale your business startup. Startups and established businesses alike can use convertible notes to fund their growth.
What is a convertible note?
A convertible note is a short-term debt that converts into equity. Any business can sell convertible notes, but it’s common for a startup to do so before receiving its first valuation and Series A funding.
Convertible notes provide startups with an initial round of financing, without the need to come up with a valuation for investors or a proof of profits for banks. Unlike regular debt, instead of getting repaid in principal and interest, investors receive preferred stock based on the terms set in the convertible note.
Common terms to know
Convertible notes are offered to investors with specific repayment terms. These terms vary and will include factors like when the notes mature, the interest rate, and how deep the discount will be for future stock.
Here’s a look at some terms associated with convertible note investments:
Preferred stock: Offers some priority over other shareholders (e.g., common stockholders) when getting dividends (which are fixed), and provides additional protections from bankruptcy and dilution. However, it doesn’t come with voting rights, making it appealing for founders who want to maintain control.
Common stock: Allows investors to elect the board of directors and have a vote in the company. There are different classes of common stock, some with more voting rights than others. However, since it has fluctuating dividends, it carries more risk. Its pricing also has higher short-term volatility, so it’s better to hold long term to increase the odds of a positive return.
Discount rate: A reduced price (e.g., 10% to 35% lower) for when notes convert into equity. For instance, if the market rate is $2.50 per share and the convertible note has a 20% discount, the note holder can buy shares at $2.00.
Conversion valuation cap: Creates a ceiling to limit the price convertible debt converts at when becoming equity. It allows investors to convert notes at a lower price than funding round investors.
For example, if the cap is $2m and the valuation after Series A funding is $3m, the notes will still convert at the valuation of $2m.
But be wary of setting a low valuation cap because it can leave note holders with a large percentage of ownership. And it can dilute your stakes and that of future investors, making it harder to get future funding.
Interest rate: The interest rate on convertible notes varies between 2% and 8%, and is normally lower than traditional loans.
Maturity date: Convertible debt typically matures after 12-24 months. At this time, if the notes didn’t convert into shares, the investors are repaid their note investment plus interest. Otherwise, the investor can hold their shares to cash out at a later date.
How does a convertible note work?
Convertible notes start as short-term debt and later convert into equity for investors. When an investor’s note converts into equity during an agreed upon funding round (e.g., Series A), the price is lower per share compared with what other investors will pay.
For example, convertible note holders’ stocks might convert into equity at $0.50 per share, while others will pay $1 per share.
If a startup falters and goes bankrupt, the convertible note holder is at risk of losing their investment. When the company liquidates, senior debt holders of venture debt, credit card debt, and lines of credit receive payment first.
An alternative for investors is senior convertible notes, which take priority over all other equity holders and debts (e.g., founder’s equity, bonds) in the event of a bankruptcy.
Once the maturity date hits, what happens next depends on the terms of your notes. For instance, some exercise their option to request cash repayment, while others prefer to allow conversion into company shares, or to roll over the maturity date.
If cash is required, you must find funding to repay the loan or risk being sued and having your business assets sold to satisfy the debt. Some investors won’t sue and will instead extend the maturity date to allow the startup to grow or secure funding.
If an investor opts to convert the debt into equity, the price it converts at depends on the valuation cap or the discount rate.
Here’s an example:
You sell $1m in convertible notes to an investor with a valuation cap of $10m, and a 30% discount rate. After 18 months, your startup gets a pre-money valuation of $20m, at $20 per share, during a Series A funding.
Now, the investor will convert their notes based on the valuation cap method ($10m) or the discount (30%) method, whichever has a lower price.
To calculate the valuation cap conversion, take the valuation cap, divide it by the pre-money valuation, and multiply it by the pre-money valuation price per share. In this case, it’ll work out to $10m ÷ $20m x $20, or $10 per share.
In comparison, investors from the Series A funding will pay $20 per share. This is a 50% discount, and will reward the note holder with 100k shares ($1m investment ÷ $10/share = 100k shares).
If the conversion uses the 30% discount, the convertible note holders will pay $14 per share — a higher price than the valuation cap conversion. Therefore, the valuation cap method will be used in this case.
What are the pros and cons of convertible notes?
- Faster, cheaper, and easier to negotiate (with investors) compared with funding rounds that require a business valuation.
- Ideal for startups with no financial history.
- Can help limit dilution for original shareholders.
- No worries about investors “controlling” business decisions during the early stages of the startup.
- Safer for investors than regular equity, since it works like debt until the company hits milestones (like a funding round).
- Delays repayments to investors until the company has matured.
- Outsized ROI for investors with high-growth startups.
- Founders eventually give up some control over their business (if note holders convert to become shareholders).
- For investors, calculating the return is more complex than a traditional loan or investment (having to factor in interest rates, discount rates, valuations, and maturity dates).
- If the startup won’t or can’t raise subsequent equity financing, it may not have the money at maturity date to repay the note.
- It’s often used for early stage startups, which have a higher risk of failure.
Why are convertible notes used by startups?
Most investors want to see a valuation before opening the purse strings, but it can be difficult to value a business in its early stages, which makes raising Series A funding challenging. With convertible notes, startups can receive the capital needed before the valuation stage.
For investors, it’s not always easy to tell which startup has the greatest potential, and convertible notes can help limit the downside. If the startup never reaches a high valuation, the note holder can still be repaid in cash as they’re technically debt holders until the conversion event.
Offering convertible notes is an effective way to get seed investors’ attention, especially if the future of the startup’s industry is bright. It allows investors to get in early and potentially cash out big if the startup’s a success.
And it’s a win for founders because they can operate and grow their businesses without needing to consult with investors (as they’re initially note holders, not shareholders with votes).
Convertible note examples
There are several ways to structure convertible notes. For instance, it could look something like this:
- Valuation cap is $8m
- Discount rate for shares is 30%
- Interest rate is 4%
- Maturity date is 24 months from convertible note purchase
- Cost of the notes is $200k
- Converts to preferred stocks only
A note holder invests $200k and in return will receive 20% off future share prices after the startup gets its Series A funding.
Let's say the startup raises $10m in funding. If the preferred stock price is $1.00 and the investor receives a 20% discount, then the note will convert at $0.80 per share. This equates to 250k shares ($200k divided by $0.80).
That’s 50k more shares than Series A investors will get for the same investment amount.
Now, this doesn’t include the 4% accrued interest, which is $8k per year or $16k by the two-year maturity date.
It’s common for startups and corporations to use convertible notes. For example, Bilibili, a video-streaming and mobile gaming company, announced in November 2021 that it’s raising $1.6B through senior convertible note sales to fund research, content enrichment, and debt payments.
Coinbase also announced in May 2021that it’s raising $1.25B in convertible note sales to bolster its balance sheet and minimize shareholder dilution. The timing was right because interest rates were low at the time.
When should you use a convertible note?
Getting the first investor to say yes to funding your startup is always tricky. The next best thing — offering convertible notes with favorable terms. As you grow your convertible note sales, it’ll show potential investors that others are seeding your startup, increasing their confidence in doing the same.
Here are several other scenarios where using convertible notes makes sense:
- You need funding for expenses like marketing, product design and development, and hiring staff
- You want to seed your startup without getting a valuation
- You developed a minimum viable product (MVP) that’s ready for public release
- You can offer great terms to attract investors
When should you avoid convertible notes?
Convertible notes are attractive to startups and investors. But there are situations when you should avoid using them.
Here are several:
- You lack confidence in your ability to secure future funding to repay the notes
- You haven’t validated your business idea
- Your cap or discount isn’t lucrative enough to investors
- Investors are demanding unreasonable terms
Using convertible notes to fund your startup can provide the capital boost you need. But how do you get your business in front of prospective debt investors?
“There are a few ways to go about raising or selling convertible notes,” says Stacey Lewis, an ecommerce entrepreneur and frequent convertible notes investor.
“One option is to work with an investment bank or broker-dealer that specializes in early stage financing. Another option is to work with a crowdfunding platform that provides access to a large number of potential investors.”
Some crowdfunding companies to consider include Wefunder, MicroVentures, and SeedInvest.
Lewis chose to sell convertible notes to friends, family, and angel investors. The process involved drafting a term sheet outlining the note’s terms, such as interest rate, conversion price, and maturity date.
After both parties signed the term sheet, the investor wired the funds to her company’s bank account to complete the deal.
If you decide to sell convertible notes for your business, consult with a legal or financial adviser to ensure your deals go smoothly.