Convertible note financing is a common practice among startups looking to raise early capital to finance their company. A convertible note gives investors the opportunity to transfer debt into an equity share of ownership of the company after the company has established itself rather than receive a return of interest and principal. It also gives the company the time for a fair stock price to be determined rather than in the very early stages of its operation when things are just getting off the ground.

Convertible notes issued during what is termed the Series A round, or first round of financing conducted by a startup, automatically convert into shares of preferred stock once the necessary funds have been raised. Upon completion of the Series A round, investors receive stock that entitles them to a priority claim of dividends issued by the company and other rights, based on the terms of the note.

Two Important Elements in Convertible Notes

Investors should pay particular attention to two areas in a convertible note.

  • Interest Rate: Even though the recipient of a convertible note has traded the opportunity to receive equity in the company as opposed to the payment of interest and principal, the interest rate applied to the investment can result in receiving additional shares than could be purchased if only principal is applied.
  • Maturity Date: In addition to setting a date by which the convertible note comes due, in the case of the Series A round being unsuccessful or the company becoming profitable enough not to need further financing, this provision sets the number of shares the investor will receive.

Determining Fair Value of a Convertible Note When Investing

It can be difficult to assess whether or not a convertible note is a wise investment or not, especially in the case of investors who have never purchased a convertible note before. Of course, it becomes easier if an experienced venture capitalist has already put money into the company and established terms to review. If that isn’t the case, it’s always possible to review the experiences of other startups with similar business plans or in the same industry to determine if the deal is fair.

Advantages of Convertible Note Financing for Investors

Convertible note financing, while having the usual risks involved with any investing activity, offer advantages to the early investor:

  • Get in at the ground floor: Everyone is looking for the next Apple, Microsoft or PayPal and the opportunity to receive stock in the company before it goes public is a tantalizing attraction for many investors. Receiving a convertible note for an investment is putting off the immediate reward of interest for the long-term benefits.
  • Discount rate:  Convertible notes often establish a discount rate that rewards early investors for their faith in the company before Series A investors. A discount rate of 25 percent converts into an equity share of $.075 for a share established at $1 when the Series A round winds up.
  • Valuation Cap: A valuation cap sets a maximum price above the initial total of the loan and will convert into a larger share of equity of the company.
  • Conversion Discount:  This provision gives investors the right to convert the original amount of their investment, plus an agreed upon rate of interest, into equity and therefore increase the purchasing power of the investor.

Advantages of Convertible Notes for Startups

Issuing a convertible note in return for early investment holds several benefits over raising financing that must be repaid in cash:

  • Valuation is unnecessary. There are no complicated formulas needed to determine the price of the stock. It’s just a matter of waiting until the Series A round has been completed and letting more experienced investors determine the value of the preferred stock.
  • Control maintained. Notes are converted into preferred shares, not common stock, so the owners of the business do not give up any control in the company.
  • Efficiency and Cost: Convertible notes require a minor outlay of costs for legal fees and they don’t usually involve a lot of negotiation so they can be turned around in a matter of days.

Convertible note financing is a situation where both the startup and the investor are taking a leap of faith the company will eventually enjoy success and both parties will prosper as a result of the experience.

To learn more about convertible note financing, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.