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Startup firms usually receive their funding in the form of debt or equity. Some newer ways of providing funding to the startups, which are different from both debt and equity, are still being explored. However, there are many creative ways of funding startups within the debt-equity realm as well. One of these ways is called convertible notes. It is a form of hybrid investment which has the characteristics of both debts as well as equity.
Convertible notes are not a recent invention. In fact, they have been used by investors and startup founders for a very long time and have been the reason for both the success as well as the failure of many startup firms.
In this article, we will have a closer look at what convertible notes are and how they are used in the process of funding startups.
Convertible notes are instruments that offer early investors a mechanism to invest in very early-stage startups while reducing some of the risks related to such investments. Early-stage startups are considered to be very risky for equity investments. This is because there is a good chance that the value of the equity will turn to zero. Hence, angel investors use convertible notes to make an initial debt investment in such companies. This means that when the investment is first made, it has the characteristics of debt.
The startup company has to repay principal as well as interest applicable on this amount. This amount is generally not paid back in cash. Instead, the accrued interest keeps on adding to the principal. However, the convertible notes have a clause that when the startup company reaches a certain milestone, the debt will automatically be converted to equity.
For example, if the company has been able to generate revenue of more than $1 million for six consecutive months, then the convertible note debt will be automatically converted to equity. This means that the startup company will stop adding interest to the existing debt and any outstanding principal will be adjusted by issuing an equal amount of equity shares.
There is something called a conversion discount rate which is also part of the convertible notes agreement. Conversion discount rates are the amount of discount which is given to investors that hold convertible notes. In the above point, we have mentioned that debt is converted into equity. However, we have not mentioned the price at which this conversion happens.
The conversion discount rate is the discount that will be given to the holders of convertible debt. If this rate is 20%, then new shares will be issued at $8 per share to holders of convertible debt if the market rate is $10. The conversion discount rate signifies a premium that is paid to the holders of convertible debt for taking extra risks.
Hence, convertible debt can be extinguished in one of two ways. These notes have a maturity date specified in the contract. On this maturity date, the company can either repay the principal and the accrued interest in the form of cash or can issue equity shares at a discount. However, investors who choose to invest in convertible debt tend to take on significant risks. They generally want to obtain equity shares of the company and are not interested in receiving their cashback. Hence, investors often get disappointed if they are paid back in cash at the end of their tenure.
The issue of convertible notes is not suitable for all types of companies. There are some types of companies where convertible notes are more suitable. For instance, convertible notes are mostly used in the pre-seed-funding stage. This is because founders often want to raise cash at this stage to be able to expand further but investors are not looking to buy their risky equity.
Convertible notes are also issued by companies between two startup rounds. However, convertible debt can become quite risky when there are multiple parties involved. This is the reason that there should be a clearly defined agreement that explores the roles and responsibilities of each party in various scenarios.
Convertible notes are risky, however, they can also be rewarding to both founders as well as to investors. They offer companies a mechanism to raise funding before a concrete business plan is in place. From an investor's point of view, they allow the investor to have a foothold in the company even though they do not have enough data to decide the valuation of the firm. Convertible debt allows investors to lock in their investments and then decide at a later date when they want to make a larger investment within the same firm.
Even though convertible debt can be quite useful, it should not be any founder’s first choice to raise money. Founders must explore all their other options such as SAFE notes, KISS notes and even revolving credit before they finally agree to issue convertible debt.
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