Convertible Note For Startups Explained
A typical financing situation for a startup accelerator program would be 25,000$-50,000 early seed funding for 4-8% of your startup’s equity. The question that usually comes after that is, “what form of equity did the investors take in?” Some investors like to take in a type of note called a convertible note . Let’s dive into what a convertible note is.
A note in general means a loan, usually a long term note. A convertible note for your startup is basically a loan that converts into equity or stock when your startup reaches Series A round. This allows the investor to receive equity in a form of preferred stocks instead of overtime interest. The terms are usually negotiable and is written down on the term sheet. Not all investors choose this path. Most of the bigger incubators like Ycombinator, TechStars etc. are issued stocks instead of a convertible note. Common stocks aren’t as common with the larger investors because of the risk and settlement that are involved between the founders and the investors. Preferred stocks allow the investors to have a different set of privilege and benefits. A convertible note makes the evaluation process much easier for startups and investors. One thing to keep in mind that is a note is a loan and not yet considered equity. Early common stock issues can get confusing when new investors kick in so that is why a convertible note with a good way to approach early investing.
Like with anything else in life and business, there are cons involved with convertible notes as well. This rarely happens, but let’s say your startup gets acquired before Series A. We have seen a few of these happen recently, but most of the time a startup up will run out of cash if they do not reach Series A after a long period of time. In that case, the investors lose all of their money and any note wouldn’t make a difference. Say for example your startup gets acquired before Series A, then what would happen to the investors loan? One simple straight forward solution would be for you to pay back the entire convertible note along with interest fees. An investor is not a bank, they don’t like small returns for huge risky investments, so an interest might not please them. In that case, if possible and agreeable you can convert all of their convertible notes into an agreed equity amount. Another con about convertible note for investors is that convertible notes usually does not give the investor any control rights. It is still in fact a loan and not equity until your startup has reached Series A.
Convertible Note With Cap
You might hear the word convertible note with cap a lot. Well a cap means a limit, so you might initially think, “What?! a limit on the investor’s loan?” Let’s say for example, an early investor invests 100,000 in the form of a convertible note early on with 20% discount. When you reach Series A, your startup is valued at 10 million. The investor won’t be happy with his gains. New investors set a cap with convertible notes which is agreed upon early on in the term sheet. In that situation, the loan will be converted in a maximum valuation that was agreed upon when the loan was granted even if the actual valuation of the first round of financing was much higher.
Every investor has their own way of funding startups. Other formats include royalty loans, common stocks, loans, preferred stocks and many more.