Convertible Note

Business / By /

A convertible note is a financial instrument commonly used in startup financing and early-stage investments. It represents a form of debt that can be converted into equity (typically shares of common or preferred stock) at a later stage, usually when the startup secures a larger funding round or reaches a predefined milestone. In this comprehensive guide, we will explore convertible notes in detail, covering their definition, key terms, advantages, disadvantages, real-world examples, and best practices.

What Is a Convertible Note?

A convertible note, often referred to as a convertible debt or convertible bond, is a debt security issued by a company to investors with the understanding that it will be converted into equity (ownership shares) in the future, under specified conditions. It serves as a short-term financing tool that helps startups raise capital without immediately determining the valuation of the company. Instead, the conversion price is typically determined when the startup secures a subsequent funding round, such as a Series A round.

Key features of convertible notes include:

  1. Debt Structure: Convertible notes start as debt instruments, meaning the startup is obligated to repay the principal amount (the amount initially invested) with interest. However, the intention is usually for the note to convert into equity rather than being repaid.
  2. Conversion Trigger: Conversion typically occurs when specific events or milestones are met, such as a qualified financing round (e.g., Series A), the sale of the company, or a maturity date. Investors receive equity in the company based on predetermined terms.
  3. Convertible Note Terms: The terms of a convertible note include the interest rate, maturity date (the date by which the note must either convert or be repaid), conversion discount, and valuation cap.

Key Terms of Convertible Notes

To understand how convertible notes work, it’s crucial to be familiar with the key terms associated with them:

  1. Principal Amount: The initial investment made by the investor, typically in the form of a loan to the company.
  2. Interest Rate: The annual interest rate applied to the principal amount. Interest accrues over the life of the note and may be payable upon conversion or at maturity.
  3. Maturity Date: The date by which the convertible note must either convert into equity or be repaid by the company to the investor. If neither occurs, the note may be in default.
  4. Conversion Discount: A percentage discount applied to the price per share in a subsequent equity financing round. This discount benefits convertible note investors by allowing them to purchase shares at a lower price than new investors.
  5. Valuation Cap: A predetermined maximum valuation at which the convertible note can convert into equity, even if the subsequent round’s valuation exceeds this cap. The valuation cap benefits investors by ensuring they receive equity at a favorable price.

Advantages of Convertible Notes

Convertible notes offer several advantages to both startups and investors, making them a popular choice for early-stage financing:

  1. Flexibility: Convertible notes provide flexibility in determining the company’s valuation. Since valuation is not fixed until a later funding round, startups can attract investors without immediate valuation negotiations.
  2. Quick Access to Capital: Convertible notes can be executed relatively quickly, allowing startups to secure much-needed capital for initial growth and development.
  3. Simplified Terms: The terms of convertible notes are typically straightforward, making them easier for startups to manage compared to issuing equity.
  4. Interest Rate: Convertible notes accrue interest, which can provide additional returns to investors if conversion does not occur.
  5. Conversion Discounts: Investors benefit from conversion discounts, allowing them to acquire equity at a lower price per share compared to future investors.

Disadvantages of Convertible Notes

While convertible notes offer advantages, they also come with certain disadvantages and challenges:

  1. Interest Costs: Startups may incur interest costs, which can become a financial burden if conversion does not occur promptly.
  2. Maturity Date Pressure: The maturity date can create pressure on startups to secure a qualified financing round or repay the notes. Failure to do so may result in default.
  3. Dilution: Convertible notes eventually convert into equity, leading to dilution of the ownership stake of existing shareholders, including founders.
  4. Complexity: Convertible note terms, including discounts and caps, can be complex. Poorly structured notes may lead to disputes during conversion.
  5. Legal Costs: Drafting and negotiating convertible notes may involve legal expenses, which can add to the cost of fundraising.

Real-World Examples of Convertible Notes

Let’s explore a couple of real-world examples to illustrate how convertible notes are used:

Example 1: Startup Financing

Suppose a tech startup, XYZ Tech, is in its early stages and is looking to raise capital to develop its product. To attract investors without a predetermined valuation, XYZ Tech issues convertible notes. Investor A agrees to invest $100,000 with a 20% conversion discount and a $5 million valuation cap. Investor B invests $50,000 with a 25% conversion discount and a $4 million valuation cap.

Six months later, XYZ Tech secures a Series A funding round at a $10 million valuation. As per the terms of the convertible notes, Investor A’s notes convert into equity at a $8 million valuation ($10 million minus the 20% discount), while Investor B’s notes convert at a $7.5 million valuation ($10 million minus the 25% discount). This allows both investors to receive equity at a favorable price compared to the Series A investors.

Example 2: Bridge Financing

Consider a scenario where a startup, ABC Software, has a funding gap before its planned Series B round. To bridge this gap, ABC Software raises funds through convertible notes. The notes have a 12% interest rate and a maturity date of 18 months.

ABC Software successfully secures its Series B round within the 18-month period, triggering the conversion of the notes into equity. The investors receive shares in the company at the Series B valuation, and the accrued interest on the notes is also converted into equity.

Best Practices for Using Convertible Notes

When considering convertible notes as a financing option, both startups and investors should follow best practices to ensure a smooth process:

  1. Clear Terms: Ensure that the terms of the convertible notes are clear and well-documented, including the conversion discount, valuation cap, interest rate, and maturity date.
  2. Legal Counsel: Seek legal advice to draft and review convertible note agreements to protect the interests of both parties.
  3. Exit Strategy: Startups should have a clear plan for how they will secure the next financing round or repay the notes when they mature.
  4. Communication: Maintain open communication between startups and investors to keep all parties informed of progress and developments.
  5. Due Diligence: Investors should conduct due diligence on the startup, including assessing its market potential, team, and growth prospects.

Conclusion

Convertible notes offer a flexible and valuable financing option for startups and early-stage investors. They provide a way to raise capital without the immediate need for a company valuation and allow investors to benefit from conversion discounts and valuation caps. However, convertible notes also come with challenges, such as interest costs and dilution, which should be carefully considered. When structured and managed effectively, convertible notes can facilitate the growth and development of startups while offering investors an opportunity to participate in their success.

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

profitability
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

triple-bottom-line
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Main Free Guides:

More Resources

Discover more from FourWeekMBA

Subscribe now to keep reading and get access to the full archive.

Continue reading

Scroll to Top
FourWeekMBA