Startups require capital to get up and running and typical sources of funding like equity investment take a few months to complete the legal processes. Nowadays the fast-paced startup can’t afford to lose time and this is where convertible notes come in handy.
A convertible note is a debt provided by investors which later turns into an equity stake of the company at the future valuation. Difficult to wrap your head around, right?
Let’s dive deeper into this and understand more about convertible notes and how it works.
Imagine we establish a company named “TowardsBiz” with 10,000,000 common stocks. You and I are the owners of the company and we own 5,000,000 shares each. Currently, the ownership is as follows:
|No. of stocks||5,000,000||5,000,000|
Now that we have established the company, it’s time to raise money. We find and convince an investor, Sam to invest in our company but the old school way of equity investment to raise money can take up to months so we go for a convertible note.
Interest Rate: The rate that will add up to the initial capital investment while turning the convertible note into equity.
Discount Rate: The rate that represents the discount, the investor gets while receiving the equity from the capital investment in the next funding round.
Valuation Cap: It is the cap for maximum valuation at which the convertible note will turn into equity.
Maturity Date: The date after which the investor can request for payback or execute the convertible note.
As an early startup, we don’t have enough data to valuate our company. So, Sam agrees to provide us $500k at an interest of 5% and a discount rate of 20% and get certain percentage equity at a valuation of series A funding.
Suppose after 1 year, another investor Kane valuates our company at $10 million and invests $2 million. In this case:
Interest: 5% of 500k= 25k
Discount: 20% of $10 million=$2 million
Investment + Interest = 525k
Valuation= $8 million
Investment = $2 million
Valuation = $10 million
|No of stocks||5,000,000||5,000,000||5,25,000||2,000,000|
Suppose our company does exceptionally well and Kane is ready to valuate our company at $50 million and invests $2 million. In this case, Sam who believed in us will get very little equity. The risk he took does not compensate for the returns he gets. The deal does not become fair. Sam was well aware of this and therefore put a valuation cap of $12 million for the convertible note.
Although the company was valued at $25 million, Sam will convert his note at $12 million.
Now, the equity distribution will look something like this:
|No of stocks||5,000,000||5,000,000||4,37,500||400,000|
For some reason, if our company can’t seek new investors, and the maturity date is completed Sam can either ask for his invested capital back or execute the convertible note at the valuation cap.
Or, an alternative can be if we and Sam agree on the point that we continue running the business seeking investors while he accumulates the interests.
Fundraising can be a cumbersome task with all the paperwork and lawyers involved and consume months of time thus startups use a convertible note to delay the equity, valuation process and raise the money immediately from investors.
Convertible note financing is earlier to document from a legal perspective which enables startup founders to focus on the company rather than fulfilling the legal formalities to raise money which consumes a lot of time.
Hope you have a clear understanding of the ins and outs of a convertible note. If you have any queries, please comment below. We will try our best to help you.