STARTUP FUND RAISING THROUGH CONVERTIBLE NOTES
WHAT IS CONVERTIBLE NOTE? A convertible note is a debt instrument often used by angel or seed investors looking to fund an early-stage start-up that has not been valued explicitly. The convertible note is automatically changed into equity once a specific milestone has been reached. To put it simpler, after investors initially loaned capital to a new company (startup) and it’s grown enough to repay the debt, investors wish to get a predetermined amount of preferred stock instead of receiving their money with interest.
TERMS OF CONVERTIBLE NOTES
INTEREST RATE
Convertible notes are a loan, so there’s an interest rate. The difference is that convertible notes pay interest in equity rather than cash. The interest rate is the amount that will be added to the principal amount when the note is converted. Interest rates are usually low and in line with current rates as the value is primarily in the equity conversion
DISCOUNT RATE
The discount rate or short discount is a reward reserved for investors for believing in your business early on in the game. It allows the debtholders to convert their notes at a discount of the equity valuation for the equity round or in other words to obtain shares in the business at a lower price than the price paid by equity round investors.
MATURITY DATE
It is a date indicating when the loan is due and then the start-up needs to either repay it or by this time raise a funding round.
VALUATION CAP
The valuation cap represents an additional reward for investors taking a risk by investing at the very beginning stage of a company’s formation. It entitles convertible noteholders to convert to an equity stake in the company at the lower of the valuation price, or valuation cap, in the subsequent financing rounds.
HOW DO CONVERTIBLE NOTES WORK?
An investor will provide an early-stage start-up in need of capital with a loan along with repayment terms i.e. valuation cap, discount rate, interest rate and maturity date. This is the “note.” The note will include a due date at which time it’s mature and the balance will be due, along with interest. You have to repay the investor for their loan with equity in your company.
If, however, the maturity date comes along and your start-up has not yet converted the note to equity, the investor can either extend the convertible note’s maturity date or call for the actual repayment of the note.
WHO SHOULD USE CONVERTIBLE NOTES FOR FUNDING?
Ultimately, convertible notes are designed specifically for early-stage startups in high-growth phases. To actually make use of a convertible note, your company should be in talks with potential investors at angel and seed rounds of funding. Therefore, by the time you hit your Series A funding round, you’ll have a valuation, and you won’t have to worry about your convertibles. Convertible notes are also ideal for early-stage startups who want to close funding fast.
ADVANTAGES OF CONVERTIBLE NOTES
Delayed valuation – convertible notes allow founders to delay the valuation of their startups.
Simplicity – typically an equity round requires updates to a plethora of corporate documents, which in most cases requires time and drives expenses. Convertible notes do not need that, they are usually much simpler in their form and quicker to proceed.
Flexibility – startups often need to secure some financing between larger equity rounds and some characteristics of convertible notes are very useful in such situations.
DISADVANTAGES OF CONVERTIBLE NOTES
Time-Consuming Process-Though convertible notes are far more straightforward than Series A funding, they can still be complicated and time-consuming to negotiate.
Giving Away Shares of Equity-For companies, the most significant disadvantage to convertible notes is giving away future equity that has the potential to be far more valuable than the original loan.
Failure to Secure Future Financing-There’s always the possibility that the company won’t be able to raise equity financing in future rounds. If the note matures and the company cannot get additional funding, it’s unlikely they’ll be able to repay the note. Defaulting on a convertible note can push a company into bankruptcy.
IS A CONVERTIBLE NOTE RIGHT FOR YOUR STARTUP?
One of the reasons why convertible notes are quite common among early-stage startups is, they are a hybrid of equity and debt financing. However, they may also have a serious impact on your business in the future – especially if things do not go as planned. Therefore, before deciding to use this financial instrument, make sure to understand all potential outcomes.
IN CONCLUSION
Convertible notes can be an excellent option for the right company and the right investor. The high-risk, high-reward model can offer a way for startups to obtain seed funding before they have the resources to get to Series A funding.
VK INVESTMENTS is here to help startups that wishes to raise fund for their business through Convertible notes. Contact us:
Website: https://vk-rise-investments.com
Email: [email protected] / [email protected]
WhatsApp: +1-647-945-5271 / +91 8939654691
LinkedIn : https://www.linkedin.com/in/maninagappan/
