Convertible notes – or convertible debt – have become the de facto standard for small (i.e., less than a million) seed-stage deals in the last few years.
There are two primary reasons convertible notes are popular:
They are easy to complete quickly and cheaply, keeping legal work and negotiations on both sides to a minimum. Experienced investors don’t want long and involved legal counsel in a typical convertible debt round of funding – in fact the term sheet for a deal like this could be only 2-3 pages long.
The second reason is the ability to ignore valuation, which can be the hardest factor to determine objectively.
Convertible notes used to be called ‘bridge’ financing and they worked in a couple of ways:
A VC firm that invested in the startup’s Series A funding round will make an additional investment to help ‘keep the lights on’ while the company goes out and raises another round of funding with other investors.
A VC firm will make a quick injection of seed capital when the investor and entrepreneur already know and trust each other because it’s quicker than completing a Series A round of funding.
Either way, wi6th convertible debt financing, the investment is made without placing an explicit valuation on the startup company. The investor simply makes the company a loan that will convert as part of the next priced equity round into the type of security issued to investors in that round, whatever that may be and it may include a price per share subject to a conversion discount such as 25% to compensate early investors for their relative risk..
Unlike a mortgage or other types of collateral-based business debts, the note is usually unsecured and it’s not expected to be repaid. The investor and entrepreneur are both betting on the success of the company, in which case the note will convert to equity. The conversion terms are where the money lies – literally and figuratively.
A key role for startup lawyers is to close the gap of understanding between what startup owners know about convertible debt and what investors already understand.