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Convertible Notes: A Hybrid of Debt and Equity

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There are many ways to raise financing for your company, but one of the most popular is a convertible note. With a convertible note, the investor loans money to the startup in return for equity in the company (rather than a payout of the principal plus interest).

A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.

What is a convertible note?

A convertible note is an investment vehicle often used by seed investors investing in startups who wish to delay establishing a valuation for that startup until a later round of funding or milestone. Convertible notes are structured as loans with the intention of converting to equity. The outstanding balance of the loan is automatically converted to equity at a specific milestone, often at the valuation of a later funding round. In order to compensate the angel investor for the additional risk of investing in the earlier round, convertible notes will sometimes have additional clauses, such as caps, and or discounts.

When evaluating a convertible note, there are a few key parameters that must be kept in mind:

Discount Rate

This represents the valuation discount you receive relative to investors in the subsequent financing round, which compensates you for the additional risk you bore by investing earlier. A discount in a note sets a percentage reduction at which the convertible note will convert relative to the next qualified priced round. Effectively this permits an investor to convert the principal amount of their loan (plus any accrued interest) into shares of stock at a discount to the purchase price paid by investors in that round.

Valuation Cap

The valuation cap is an additional reward for bearing risk earlier on. It effectively caps the price at which your notes will convert into equity and — in a way — provides convertible note holders with equity-like upside if the company takes off out of the gate.

Interest rate

Since you are lending money to a company, convertible notes will often accrue interest as well. However, as opposed to being paid back in cash, this interest accrues to the principal invested, increasing the number of shares issued upon conversion.

Maturity date

This denotes the date on which the note is due, at which time the company needs to repay it.

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By SeedBlink Knowledge

PublishedDecember 07, 2020


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