So you need to secure funding for your startup, but you are not sure you want to give up equity right away, especially because you do not want to put a value on your company too early. You also are not sure what your company is even worth and would like more time in order to prove your worth and build up credibility. Well, this is where convertible notes come into play. Convertible notes are a good vehicle for startups trying to find a relatively quick, relatively easy way to secure funding without having to worry about valuations, high costs, or immediate loss of control.
A convertible note allows you to seek funding, in the source of a temporary loan, from an investor without putting a valuation on your company.1 Delaying the valuation negotiation not only speeds up the process of getting funds, but it also allows you to build credibility in the meantime to support a higher valuation later on.2 In return for the uncertainty of having a valuation in place, the investor retains the right to convert his investment into equity during the next round of financing. At that time, the investor has the option to convert his note into equity, based on the valuation during the next round of financing, but with a discount; the discount is usually 20% or 25%.3 If the investor chooses not to convert into equity, he can opt to have his note paid to him, with an interest rate specified at the time the loan was made, which will typically be around 5% to 8%.4
As mentioned earlier, convertible notes benefit a startup by not forcing it to adopt a valuation too early in its life. Another great advantage is the retention of control. By not giving up any equity, the founders of the startup retain their control, so they are not encumbered in their ability to make important decisions concerning the direction of the startup.5 A convertible note also provides an investor with more security than an equity purchase: in the event the startup ends up liquidating, the owner of a convertible note, which is debt, will have priority of payment over the owner of equity in the company.6 Another very important consideration to a startup is the cost of the financing on the front end. That is, the legal fees and document fees associated with the structure of the funding. Convertible notes, because they involve less paperwork and do not require a settled valuation, cost much less than a typical equity-based investment.7
At the end of the day, if you are looking to fund the growth of your company, there are many vehicles and ways to do so. However, if you are looking for a way to secure funding quickly and at a reasonable cost, without losing immediate control of your company, and without a painful valuation process, you should look into finding and investor that is willing to accept a convertible note in lieu of immediate equity. In the long run, it may make the difference between becoming a rock star startup or a bust.
Ryan Caldbeck, When Convertible Notes Make Sense For Consumer Companies, Forbes.com (May 12, 2013, 3:35 PM), http://www.forbes.com/sites/ryancaldbeck/2013/05/12/when-convertible-notes-make-sense-for-consumer-companies/. ↩
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Fred Wilson, Financing Options: Convertible Debt, Avc.com (July 11, 2011), http://www.avc.com/a_vc/2011/07/financing-options-convertible-debt.html. ↩
Ryan Roberts, Convertible Note Interest, Startuplawyer.com (Feb. 13, 2012), http://startuplawyer.com/convertible-notes/convertible-note-interest. ↩
Bill Clark, Convertible Debt vs. Equity: Which Is Right For Your Startup?, Mashable (July 5, 2011), http://mashable.com/2011/07/05/convertible-debt-vs-equity/. ↩
W. D. Adkins, Definition of Liquidation Priority, Chron, http://smallbusiness.chron.com/definition-liquidation-priority-36955.html (last visited Oct. 10, 2013). ↩
Monica Mehta, Raising Capital With Convertible Notes, Businessweek.com (Jan. 25, 2011), http://www.businessweek.com/smallbiz/content/jan2011/sb20110125_145583.htm. ↩