Convertible notes provide additional options and flexibility for businesses looking to raise capital, as well as an attractive early-stage opportunity for investors. Convertible notes are initially sold as debt instruments with the option to convert to equity upon future conditions. This is especially useful for early-stage businesses that may have limited cash flow to support high yielding debt while also limiting initial equity dilution until the company matures.
What is a Convertible Note?
A convertible note is a hybrid security that starts out as a debt instrument that accrues interest on the principal invested. Within a certain time period or when a trigger event occurs (like a future funding round that establishes a valuation), the debt instrument can convert into equity shares, and the lender becomes an equity shareholder.
It’s important to carefully review the exact terms of each convertible note in order to understand the mechanics and timing of conversion.
What Are the Components of a Convertible Note?
There are four key factors in creating and evaluating a convertible note.
- Valuation cap: This is not the valuation of the business. Instead, the valuation cap sets the maximum cap at which the convertible note can convert into equity. When a future valuation event occurs (i.e. a funding round or a sale of the business), the debt can convert to equity. If the future valuation round is higher than the valuation cap, then the investment converts to equity as if the investor invested at the lower valuation cap. If the future valuation is lower than the valuation cap, the investment might simply convert at the new price. For example, if the convertible note has a $5 million valuation cap and the company is valued at $10 million at the time of conversion, the investors in the convertible note will convert at a share price based on the $5 million valuation. This gives the investor a potential upside to their investment in exchange for taking early risk.
- Discount rate (“discount”): The discount rate allows the convertible noteholders to convert their notes at a discount to the equity valuation for that round. The discount is applied if it results in a better conversion price for the noteholders. One scenario is if the valuation of the next priced round comes in below the valuation cap (or if there is no valuation cap set). For example, let’s say that the valuation cap for a convertible note was $5 million with a 20% discount. Then, if the next funding round occurs and prices the business at $4 million, the investors in the convertible note would not convert based on the valuation cap since it is higher than the new valuation. Instead, the conversion could be based off of the discount of 20% (i.e. $3.2 million).
- Interest rate: The interest rate is the interest due while the convertible note is still a debt instrument. The interest accrues on the note and is not paid out until maturity, if at all. Upon conversion, interest is included in the principal to determine the amount of conversion.
- Maturity date: If the note does not convert by the maturity date, the investor may have the right to call the note and receive repayment of their principal plus accrued interest, or the note may convert upon maturity.
What Are the Pros and Cons of Investing in Convertible Notes?
Like other investment opportunities, convertible notes provide a number of different risks and benefits to potential investors. These include factors related to both convertible notes in general and specific investments. Investors should carefully read the terms of each note they’re considering as it may affect the risk and potential return of that note.
No Need to Set a Valuation Early On
Startups are often raising capital very early on. Although a startup may have a lot of potential, there is generally no clear track record or metrics to base a valuation on. Convertible notes offer investors some protections and upside potential without committing to a set price.
Potential to Reduce Early Downside Risk
Convertible notes offer some potential reduction of early downside risk. This comes from debt holders having priority over equity holders if the company is dissolved. When holding equity in a dissolved company, you would only receive money back if the debt holders were paid in full. However, if the note hasn’t converted and is still in debt form, you’d be treated as a creditor in potential bankruptcy proceedings and would be splitting any remaining cash or assets with the other debt holders (rather than the lower-priority equity holders).
Ability to Share in Greater Upside Than Traditional Debt Holders In exchange for receiving higher liquidation priority and regular interest payments, traditional debt holders accept a fixed return with no additional upside if the company does well. Convertible note holders have the ability to convert to equity, giving these investors the same upside potential as equity holders.
Notes May Be Harder to Evaluate and Compare
Even when you’re confident in the company you’re investing in, it can still be difficult to compare individual notes. With traditional debt securities, yields or investment multiples are defined and based off projected cash flow, whereas convertibles may have different discounts, valuation caps, and conversion provisions which make direct comparisons more challenging.
Maintaining a well-diversified portfolio rather than investing everything into what you pick as the “best” convertible note may also help to reduce your risk.
Lack of Ongoing Payments
Traditional debt notes make periodic interest payments that provide two benefits to investors. First, you receive a regular cash flow. Second, as you receive money back, your maximum potential loss decreases (for example, if you’ve received $50 in interest on a $1,000 note, your worst-case scenario is coming out $950 behind rather than the entire $1,000).
Convertible notes rarely provide immediate cash return due to the interest generally being accrued over the term instead of paid out; however, investors receive potential upside with the equity stake upon conversion. Lack of Control in the Company
Convertible noteholders generally have little-to-no control over the company. During the debt stage, you have the same voting rights as a debt holder, which are none. During the equity stage, your voting rights would usually be only a very small percentage of the total votes because you typically don’t receive equity until the company reaches a certain size. You may also be required to accept a proxy that is designated to vote on behalf of all convertible note holders for crowdfunded offerings due to the sheer number of potential persons involved. For smaller investments, this lack of control would be no different than owning a tiny fraction of an S&P 500 company. If you wish to make a larger investment and take a more active role in the company, you’d need to take a careful look at the structure of the deal to determine if a convertible note investment would meet your goals.
What are the Pros and Cons of Raising Capital Using Convertible Notes?
Companies of at all stages may find advantages and disadvantages to using convertible notes. This includes both startups and established companies. As with other funding decisions, you’ll need to weigh the pros and cons against your other options.
Avoid Early Cap Table and Valuation Issues
The biggest advantage for early-stage companies is the ability to preserve your cap table and not have to issue equity at a defined valuation. A common concern with selling equity early on is giving up too large a percentage of your company, losing out on control and future gains, and not having enough equity remaining to sell in future rounds. At the same time, investors may want the upside of equity to take on the risk of investing in an early-stage venture. Further, without established revenues, sales, and growth numbers, it can be difficult to reach a fair valuation.
By delaying the conversion to equity until later at a future price to be determined, a convertible note avoids all of these questions.
Avoid Having to Make Regular Payments to Investors
Companies struggling to find free cash to grow may not want to tie up their cash flows with fixed principal and interest payments. While convertible notes do carry interest, remember that the terms of the note usually call for it to be added to the principal instead of paid out as cash. In addition, there are no ongoing principal payments on a convertible note.
Potentially Lower Debt Costs
You may have tried to find a traditional loan but found that the interest rate is too high. This is because investors view your company as risky, and the interest is compensation for taking on the commensurate level of risk. A convertible note can potentially be a lower cost debt option to both growing and established companies. Convertible notes compensate investors for taking on risk in two ways — interest and equity upside. Since they also have the equity upside, investors are typically willing to accept a lower interest rate than traditional debt securities. While many convertible notes are geared towards high growth and future funding rounds, the note may be structured according to business needs and investor appetite.
Speed of Raising Capital
Convertible notes are closer to debt than equity in terms of speed of raising capital. That’s because equity raises usually require additional work to determine a valuation and protect existing shareholders against dilution. By deferring the equity-related decisions to the future, you can treat a convertible note round almost the same as a debt round.
Delay or Avoid Investor Control
If you’re concerned about selling equity because you don’t want to dilute your control over the company, using convertible notes allows you to delay or avoid giving up control. Remember that while the note remains debt, the debt holders don’t have a voting interest.
You have a few options about how you want to handle things when the notes convert. The first is by deciding that you need the most control at the earliest stages of growth and once you reach the funding round that triggers conversion, it’s OK to give up a little control. If you don’t want to give up control at that point, you can have the convertible note convert to preferred stock or a common stock class with reduced voting rights.
Giving Up Equity
Keep in mind that although a convertible note is similar to debt for many purposes, you are still committing to give up potential equity shares. As with any other equity, this means that investors will receive a permanent share in your future profits, and your own share will be proportionally reduced. This can be a smart business move, but if it’s not something you’re comfortable with, you may want to consider traditional debt instead.
Risk of Having to Repay the Note at Maturity
There is a risk that your investors could call the convertible note at maturity if you haven’t met the conditions for conversion, although a convertible note may automatically convert investors at maturity. This could lead to you having to divert cash you intended to use to grow your business, raise additional funds at potentially worse terms, or be forced into default if you have no ability to repay the note.
Is a Convertible Note Right for You?
A convertible note provides a mix of debt and equity advantages to both investors and businesses looking to raise capital.
Convertible notes are most commonly issued by early-stage companies. These companies provide the potential for higher returns but may be harder for individual investors to effectively evaluate.
Startups and other early-stage companies are increasingly turning to platforms like NextSeed to help them connect with investors. NextSeed conducts diligence on businesses to ensure their leadership team and business plan meet specific standards so that investors may make informed investment decisions based on the terms of the note and information in the prospectus.
Investors will need to look at the terms of each note and how it fits into their investment objectives and overall portfolio. A good starting point is exploring some currently available investment opportunities.
Business owners will need to look at their other financing options and how a convertible note matches their own business objectives. You can learn more about convertible notes and all of your other financing options by submitting a quick pre-qualification application to raise capital for your business on NextSeed.