For some start-ups, using convertible notes to raise equity is an effective solution when traditional means have been exhausted or aren’t available
In this edition of our Founder Series we explore the convertible note as an option to raise equity for your start-up.
In future editions of this series, we will explore other fundraising options including:
- SAFE notes
- Equity Crowd funding
- Venture capital funding
What are convertible notes and how do they work?
A convertible note is a type of short-term debt that usually converts into equity upon the closing of an investment round (also called maturity or a liquidity event).
Depending on the terms of the note (and normally the party in control of the drafting), the note holder (investor) may have the option to convert the debt, subject to the terms of the note and at an agreed conversion price. The note simply represents the debt owed to the company. Usually, on maturity or the triggering of a ‘conversion event’, the investor can require the return of the funds advanced, or require the note to convert to equity (shares).
Convertible notes can be a valuable tool for start-ups in their early stages as it gives companies the opportunity to raise funds where traditional methods, such as bank loans or share subscriptions, may not be available.
Convertible notes are an alternative funding option for founders that expand the scope of potential lenders, and attract lenders who may not otherwise invest in a start-up.
What should I know about discounts and conversion caps?
Convertible notes are often structured so that investors get a discount on the price of shares when their money converts to equity. For example, if:
- An investor lends $100,000 at an agreed 10% discount; and
- At the subsequent funding round, the shares are worth $1 per share
The investor will only pay 90 cents per share and get a greater shareholding than the next round of investors.
Another common feature included in convertible notes is conversion or valuation caps, which cap the price at which money converts into equity. Lenders will often seek to include a cap in the terms of the note to mitigate against the risk of receiving a small shareholding if the company is valued much higher than expected.
Taking the above example, if:
- I invest $100,000; and
- Later the company is valued at $100 million
When my money converts on maturity, I only get a 1 per cent share in the company. If a $10 million cap were imposed, then my investment would get me a 10 per cent share in the company.
What are the advantages to using convertible notes to raise equity for founders?
- Flexibility: if drafted on founder’s terms, it gives founders the flexibility to choose whether to continue to treat the sum advanced as debt, or determine an appropriate milestone or expiry date that triggers the option to convert
- Less complexity: the arrangement is governed by the terms of the note (for example, a convertible note and loan deed) agreed between the investor and company
- Increasing opportunity: it attracts investors who may not invest through other methods. It is also more likely to attract investors who are committed to your idea
- Valuation: it is difficult to value a company in its infant stages. Convertible notes mean companies can receive investment, but defer the valuation to a later stage
- Control: given the investors will not be shareholders right away, founders and existing shareholders retain the rights attached to ownership
What are some key concerns for founders and investors?
As a founder, a key concern associated with using convertible notes to raise equity is the inherent uncertainties. These include:
- Whether the company will even raise subsequent equity funding
- When the note will convert to equity
- Whether an investor will elect to convert at maturity.
Another key concern is the inevitable dilution of decision-making control when an investor becomes a shareholder, securing ownership in the business in its infancy. Meanwhile, early investors are willing to lend money to your company at this pre-valuation stage, which may suggest they see potential in your idea and want to support it.
But these risks must be balanced against the risk of deterring prospective investors. From an investor’s perspective, convertible notes are attractive because it means the investor enters the relationship with flexibility and can determine when they want their money to convert to shares in the company. It’s likely that things like discounts and valuation caps will be non-negotiable for investors.
To manage these competing interests and mitigate risks, founders can seek protections in the terms of the note. This involves:
- Careful drafting
- Considering terms such as the conversion and interest rate
- Considering whether or what the conversion triggers are
- Identifying who has the right to determine when conversion occurs
The convertible note will contain a clause that deals with the debt converting to equity. This clause is often more favourable to the lender. However, the terms of the notes can be negotiated and founders can seek reciprocal rights to determine when a debt converts to equity or to impose conditions on how and when money converts to shares.
The final word
For more information about the latest terms and phrases in the world of equity capital raising, take a look at our Guide to understanding start-up and capital investment terms.
Using convertible notes to raise equity will not suit every start-up business. But for many, it can be a highly effective fundraising device. With careful consideration and planning, we help our clients navigate these complexities. However, there’s rarely a one-size-fits-all approach, which is why it’s critical to seek our skilled legal advice if you’re considering using conversion notes to raise equity.