Understanding Convertible Notes in Early-Stage Investments

Most people think of fundraising in simple terms: an investor gives you money, and in return, they get shares in your company which shares represent a percentage of the business. While this is the commonly understood form of investment, it’s not the only way startups raise money.

For early-stage businesses, one of the biggest challenges is determining their value. At this stage, it’s difficult to put a price on an idea that has yet to generate significant revenue or traction. This is where convertible instruments come into play, allowing startups to raise funds without immediately setting a valuation. The two most common types of convertible instruments are Simple Agreements for Future Equity (SAFE), and Convertible Notes.

While the focus of this blog post is Convertible Notes, you can read more about SAFEs in our blog post here, Understanding SAFE: Simple Agreement For Future Equity

What Is a Convertible Note?

A convertible note is a loan provided by an investor to a startup, with the understanding that instead of being repaid in cash, it will typically convert into equity at a future priced funding round or at a pre-determined date. However, if no qualifying financing occurs before the maturity date, the investor may have the option to request repayment or renegotiate the terms.

Advantages of Convertible Notes.

1. Simpler Deal Terms: Unlike traditional equity investments, convertible notes involve fewer complexities.
2. Faster Investment Cycle: The negotiation process is quicker, allowing startups to access capital sooner.
3. More Control: Founders retain decision-making power at this stage since they are not immediately giving away equity.
4. Defer Valuation: The company’s valuation is determined later, when there is more data to support it.
5. Cost-Effective:  They typically involve lower legal fees and administrative costs compared to traditional equity rounds.

Key Features of Convertible Notes

1. Conversion to Equity: Instead of repaying the investor in cash, the note converts into shares, usually at a discount or with other incentives.
2. Discount Rate: Investors often receive a discount (typically 10%-30%) on the price per share when the note converts.
3. Valuation Cap:  A maximum valuation at which the note will convert, ensuring early investors receive a fair share if the company’s value skyrockets before the next funding round.
4. Interest Rate: Convertible notes accrue interest (often 5%-8%), but instead of cash payments, the accumulated interest is added to the loan and converted into equity.
5. Maturity Date: If no funding round occurs within a set period, investors may demand repayment of their principal and accrued interest or renegotiate terms.

Risks and Considerations

1. Uncertain Future Valuation: The terms at which the note converts may not be as favorable as expected.
2. Dilution Concerns: Issuing shares to investors upon conversion means founders will own a smaller percentage of the company.
3. Repayment Risks:  If no additional funding is raised before the maturity date, the startup may need to repay the loan, which could strain its financial position.

Conclusion

Convertible notes provide startups with a flexible and efficient way to raise capital while postponing valuation discussions. If you’re a startup founder or an investor, understanding convertible notes can help you make informed decisions about early-stage funding. While they aren’t a one-size-fits-all solution, they remain one of the most accessible and cost-effective ways for startups to secure early-stage financing and scale effectively.

Outro

This is a brief overview of how convertible notes work and why they can be a valuable tool for early-stage funding. If you have any questions or need guidance on structuring a convertible note that aligns with your business goals, please reach out to info@lwlaw.com , and our team would be happy to assist.