A convertible note is a debt instrument. Here, when the investors invest in a start-up in return, they receive an instrument. This instrument states that the investors would get equity in the company at a future date.
This saves the founders from doing a valuation for their company in the early stages. These are usually issued to seed investors. This conversion of investment to equity happens at a later funding stage like Series A.
Why do start-ups use convertible notes?
When start-ups are looking for investment but they do not want to engage in the valuation of their company they choose the convertible notes route.
This proves to be extremely helpful since in the initial stages it is a bit difficult to estimate the value of a company.
What happens when a convertible note matures?
The convertible note instrument usually contains a discount term. Wherein, when the convertible note matures the investors, get a discount when they convert their investment into equity.
For instance, let’s suppose a convertible note states that the investor gets a 20% discount.
So, when at a future stage the company is issuing equity for investment the investor would be able to get equity at a discount of 20% whereas others will have to pay the full amount.
In another situation, if on the maturity of the convertible note the company hasn’t had the required fundraising round, the investors could demand their money back.
Terms of Convertible Notes
Conversion Discount –
When investors want to convert their funds into startup equity, they receive a discount to the extent mentioned in the convertible note.
Let’s suppose your conversion discount is 20% and at the required fundraising round one share is worth Rs. 50. So, you will be able to make the conversion for Rs. 40/ share.
Interest Rate –
To help investors benefit from investing the funds they receive interest. The interest rate in which their investment will be getting in mentioned in the convertible note.
Valuation Cap –
Another term used for the valuation cap is conversion cap. This helps to protect investors. It sets the limit on what could be the value of the company. In a way, this term works to ensure that the investors get a considerable stake in the company.
For example, if an investor invests Rs. 5,00,000 and the company gets valued at Rs. 5 Crore, then that amounts to only 1%. In such a situation it becomes important to safeguard their investment and award them for the risk they took in the beginning.
Maturity Date –
There are convertible notes that also include a maturity date. However, keeping the unpredictable timeline of start-ups into consideration these usually come with an extension clause. In most of the cases, the maturity date is the next fundraising round.
Convertible Notes prove to be beneficial for both the start-up as well as the investors. However, one must move forward with caution. The terms of these convertible notes could become a matter of concern for the founders if not given due attention.