Convertible Notes 101

As a startup founder, one of your most important roles and one which will occupy a significant amount of your time (and create a commensurate amount of stress) is raising capital to fund your business.  The first formal round of investment capital raised is referred to as a seed round with consequent rounds termed alphabetically:  Series A, Series B, Series C, etc. If you’re really killing it, you might have a mezzanine round and then even an IPO.  Regardless, you will need to raise money to get out of the starting gate so prepare yourself with what you need to know.

One term that will come up early in the fundraising process is the convertible note.  This kind of convertible is not as sexy as the shiny red kind, yet it is just as desirable for the startup founder.  Why, you may ask?.  Let’s get into the details.

What is it?

A convertible note is an investment vehicle used by early stage seed investors to invest in startups, sometimes with a discount or a cap.  Think of it as a loan that converts to equity (usually shares of preferred stock) at the closing of a more formal fundraising round (ie. a Series A round) or when the startup reaches a specified milestone.  A convertible note is a loan and thus the company does not need a valuation.  A discount might be offered to the investor to compensate for the risk of investing early.  Typical discounts range from 10%-35%.  A greater discount can be offered to those investors who come in early and assume more risk.  A cap might be included in the terms as well.  A cap on the investment means that the maximum valuation at which the investment can convert at the next round of financing is set in advance.  This means that investors in the convertible note would have their investment convert to equity at the lesser of the capped valuation or the valuation of the next funding round.  A cap protects early investors thus allowing them to share in any increase in value after their investment.

Why use it?

There are a number of reasons that a convertible note is a desirable investment vehicle. They include the following:

• Valuation:  Using a convertible note defers the valuation determination until a later round or until a specified milestone is reached.  One benefit of this is that it gives the company time to get further along with its business, cull more data points on which to base a valuation, or allow an initial valuation to be set by a professional, institutional investor (read: VC) as opposed to a seed investor or friends and family.

• Costs:  Another key benefit for the startup founder is that it often saves the underfunded company thousands of dollars in legal costs.  If you don’t already know it, legal fees can be significant, $20,000-$50,000 and more for a Series A round is not unheard of.  A convertible note agreement could cost as little as $2000 or even less.

• Speed:   Closing a convertible note round can happen right away, even in a day.   A Series A round can take weeks or months to negotiate.

• Control:  The company does not usually give up any control to investors in the note.  Investors in preferred stock can receive a board seat and other control rights.

Early on, keep it simple so that you can focus on building your company.  The convertible note enables you to do this.
If you have a potential investor and you are discussing a convertible note, congratulations. You are on your way to building your company and maybe to one day owning that shiny red convertible.