When financing a business, convertible promissory notes are your secret weapon. They’re a clever mix of loan today and potential stock tomorrow, fueling your dream without slicing up your ownership pie too soon.
This blog aims to demystify their workings, benefits, and considerations, offering an overview for anyone looking to explore this flexible financing option.
What Is a Convertible Promissory Note?
Convertible Promissory Notes are financial instruments commonly used in the early stages of a business. They represent a loan from an investor to the company that, unlike a traditional loan, can convert into equity, typically preferred stock, under specific conditions.
The appeal of such notes lies in their simplicity and flexibility, serving as a convenient way to secure funds without immediately establishing a company valuation. This type of financing bridges the gap until the company is ready to raise more substantial equity rounds.
Benefits of Convertible Promissory Notes
- Convertible promissory notes provide a quick and uncomplicated financing option for businesses.
- These notes allow businesses to defer valuation discussions, benefiting companies expecting significant growth.
- Investors have the potential to convert the loan into equity at a discount, aiming for a high return on investment.
- The process of issuing convertible notes is less cumbersome and expensive compared to priced equity rounds, in terms of legal fees and time.
- Convertible notes are an attractive financing option for both businesses and investors.
Differences from Traditional Loans
Convertible promissory notes stand on their own in contrast to other financing mechanisms like traditional loans, where debt does not convert into equity, and direct equity investments, which will lead to establishing a company’s valuation upfront.
► READ MORE: Loan Agreement vs Promissory Note: Debunking Misconceptions
Key Terms of Convertible Promissory Notes
As a business owner or investor, you have to understand the key components like the valuation cap, maturity date, and conversion price, which play crucial roles in balancing the interests of both founders and investors.
Valuation Cap
The valuation cap sets a maximum valuation at which the note can convert into equity. This cap is designed to reward early investors by ensuring that their investment converts into equity at a lower valuation, granting them a larger percentage of the company compared to later investors, should the company’s valuation increase significantly.
It serves as a form of protection for investors, ensuring they do not lose out on the value of their early support of the company.
Maturity Date
The maturity date of a convertible promissory note specifies when the loan amount and any accrued interest are due to be repaid to the investor if it hasn’t converted into equity. This date creates a timeline for conversion or repayment, adding a layer of protection for the investor.
In practice, many negotiate to extend the maturity date or convert the outstanding amount into equity to avoid repayment in cash, which could be challenging for early-stage companies.
Conversion Events
Conversion events are pivotal moments that dictate when and how a convertible note will convert into equity. Typically, these events are tied to a subsequent equity financing round where the business raises capital by issuing equity.
The conversion could also be triggered by a sale of the company or, in some cases, upon the maturity of the note if specified in the agreement.
As an investor, it’s essential to clearly understand the conditions under which your note will convert, including any specific terms like valuation caps or discount rates, to assess the potential return on your investment.
Conversion Price and Discount Rate
The conversion price is the price per share at which the convertible note will convert into equity. This price often involves a discount rate, a percentage reduction offered to note holders compared to the price of shares in a subsequent equity financing round.
This discount compensates the investors for the higher risk they take by investing early. The conversion price can be affected by the valuation cap and discount rate, ultimately determining the amount of equity the investors receive upon conversion.
Post-Money Valuation
Post-money valuation plays a significant role in determining the amount of equity convertible note holders will receive upon conversion. It represents the company’s value after the completion of an equity financing round, taking into account the new funds raised.
A higher post-money valuation can potentially dilute the equity share for noteholders unless protective measures like valuation caps are in place. These caps ensure that investors convert their debt into equity at a more favorable rate, securing a predefined maximum valuation of the company for the conversion calculation.
Treatment at Maturity or Sale
When the loan is due, it can be converted into shares, or repaid with interest, per agreement conditions. If the business excels, the note becomes equity at a predetermined rate, benefiting both parties through future growth and aligned goals.
However, if it doesn’t succeed, the loan is repaid with interest, ensuring some financial stability for the investor. Thus, the method at the due date or sale is key in evaluating convertible loans, as it impacts potential gains and protections for both investors and businesses.
When to Use a Convertible Promissory Note
Thinking of how this can be implemented? Here’s a snapshot of situations calling for the strategic use of a convertible note:
Early Stage Funding
When a company is in its early stages and does not have a solid valuation or revenue stream, a convertible promissory note can be used as a form of debt financing. This allows the company to raise funds without having to give a specific valuation to the investors.
Uncertain Valuation
If a company is unable to accurately determine its valuation at the time of fundraising, a convertible promissory note can be used. This allows the company to delay the valuation negotiation until a future equity financing round, at which point the note can convert into equity.
Bridge Financing
When a company needs short-term financing to bridge the gap between two funding rounds or to meet immediate financial obligations, a convertible promissory note can be used. It provides flexibility in terms of repayment and conversion into equity.
Angel Investor Investments
Convertible promissory notes are commonly used in angel investor investments. Angel investors often invest in early-stage companies with uncertain valuations and evolving business models.
The use of a convertible promissory note allows angel investors to provide funding without immediately determining the valuation or equity ownership percentage. The note can then convert into equity at a later stage when the company’s valuation is more certain.
About SAFE Financing
SAFE financing, or Simple Agreement for Future Equity, is a contract type often used for startup companies where investors provide funds to the business in exchange for rights to equity at a later date.
While both convertible notes and SAFE financing are popular instruments for companies to raise capital without immediately setting a valuation, they have distinct characteristics, advantages, and disadvantages. The following table demonstrates the pros and cons of each:
| Feature | Convertible Notes | SAFE Financing |
|---|---|---|
| Flexibility | High, with the ability to set future valuation caps and discount rates. | Lower, due to the straightforward nature of the agreement without many negotiable terms. |
| Interest | Can accrue interest, providing an additional reward to early investors. | No interest accrues, simplifying financial management. |
| Familiarity to Investors | Widely known and accepted among investors. | Less familiar, which may complicate negotiations. |
| Maturity Date | Presence of a maturity date may pressure the company for a conversion event or repayment. | No maturity date, reducing pressure on the company but could lead to indefinite conversion delays. |
| Potential for Dilution | Accrued interest increases the conversion amount, potentially diluting future equity raises. | Potentially less dilutive since no interest accrues, but terms of conversion are fixed upfront. |
| Execution Speed | Variable, as it can involve more complex negotiations and paperwork. | Generally faster due to its simplicity and the absence of debt-like features. |
How Do Convertible Notes Work?
Before you start engaging in convertible notes, you need to understand how they work!
Issuance & Terms
A convertible note is a type of debt instrument issued by a company to investors. The note specifies the principal amount, interest rate, maturity date, and conversion terms. The terms may include a conversion price, conversion ratio, and other provisions.
Conversion Mechanics
The main feature of a convertible note is its ability to convert into equity of the company at a later date. The conversion mechanics define how and when the conversion occurs. Typically, the conversion is triggered by a specified event or condition, such as an equity financing round or a change of control.
Conversion Triggers
Common triggers include the occurrence of an equity financing round, such as a Series A funding round, or a change of control event, such as an acquisition or IPO. The conversion trigger determines when the note will convert into equity.
Valuation Cap and Discount
The valuation cap sets a maximum valuation at which the note can convert into equity, providing investors with downside protection. The discount rate gives investors the option to convert their note at a discounted price compared to the valuation of the next financing round.
The conversion of promissory notes into equity has a direct impact on the company’s capitalization table (cap table), which outlines the percentage ownership of all shareholders. Convertible notes initially appear as a liability on the company’s balance sheet.
Conversion Calculation
The conversion calculation determines the number of shares the note holder will receive upon conversion. The calculation can be based on the conversion price, conversion ratio, or a combination of both.
The conversion price is determined at the time of issuance, while the conversion ratio is based on the value of the company in a future financing round.
Equity Ownership
Upon conversion, the note holder becomes an equity holder in the company. The exact equity ownership percentage depends on the terms of the convertible note, the conversion price, and the company’s valuation at the time of conversion.
The note holder’s ownership stake is determined by dividing the number of shares received upon conversion by the total outstanding shares of the company.
Case Studies
A variety of successful companies have effectively used convertible notes for their funding needs. Dropbox is a prime example, having utilized convertible notes in its early stages to defer establishing a firm valuation until a future equity financing round.
Similarly, Airbnb also turned to convertible notes for its initial funding, enabling it to swiftly gather capital without the immediate necessity of a company valuation.
Conclusion
Funding a business can be both exciting and nerve-wracking. Convertible promissory notes offer a flexible and efficient way to secure funding without immediately setting a company valuation. This flexibility is crucial, especially in the early stages when valuing a company can be challenging.
These notes provide benefits such as:
- Deferred valuation discussion until a priced equity round
- Simplicity and lower legal costs compared to equity financing
- Potential incentives for investors, like conversion discounts
Ultimately, convertible notes strike a balance, catering to the needs of both businesses seeking capital and investors looking for opportunities.
