Startup investing and funding is challenging but essential for any founder. Since most early-stage startups aren’t yet profitable and self-sustaining, companies need to look for external sources of financing. This includes angel investors, venture capital firms, and even friends and family.
One increasingly popular form of startup funding is a convertible note, which combines aspects of both debt and equity financing. But what is a convertible note? A convertible note is a short-term debt instrument that automatically turns into equity when a predetermined milestone or conversion event occurs. Essentially, a convertible note functions like a business loan that converts into equity instead of being repaid..
So what are the benefits of a convertible note vs equity, and what are the key differences between convertible notes and SAFEs (another fundraising instrument)? Find out below.
How do convertible notes work?
It’s important to understand how convertible notes work. Traditionally, investors know a startup’s valuation before a fundraising round because the valuation determines how much equity they receive. However, if the business is too new for an accurate valuation, this may be difficult or impossible to determine.
Convertible notes help solve this dilemma by using the concept of “convertible equity.” Convertible notes can be issued during the pre-seed or seed funding stage. They can then be converted into equity once the company has a valuation (e.g. during Series A fundraising).
Here are some crucial terms for understanding convertible notes:
- Interest rate: Convertible notes function as a debt instrument. They have an interest rate attached like any other loan. However, in this case, the “interest” is paid in the form of business equity, rather than cash. That means investors receive a greater number of shares upon the note’s conversion than they would have received from their initial investment.
- Discount rate: Investors who provide startup funding in the form of convertible notes receive a discount when buying shares later. For example, if the discount rate is 30 percent and the company later sells shares for $10, convertible note investors can purchase shares at a rate of $7 instead.
- Valuation cap: Convertible note investors are also rewarded for taking on risk in the form of a valuation cap. This figure is an upper limit on the company’s valuation when the convertible note turns into equity. For example, if the company is valued at $5 million but the valuation cap is $1 million, investing $100,000 will give 10 percent equity in the business.
- Maturity date: The maturity date of a convertible note is the final day by which the business either needs to repay the loan or extend the agreement.
Convertible note vs. equity
When it comes to convertible notes vs. equity, which fundraising option should startups use? Here are the factors to consider in convertible debt/equity financing:
- Costs: Equity financing is often less expensive to the business than convertible notes. As discussed, convertible note investors are compensated for the higher risk profile in the form of discount rates and valuation caps.
- Ease of fundraising: Equity financing is the traditional form of startup fundraising, so it will likely be easier to generate investor interest. However, some knowledgeable investors with an appetite for risk may prefer a convertible note arrangement.
- Ease of use: Convertible notes are generally simpler to execute than equity financing. Convertible notes can be issued in a matter of days (and with little legal red tape). However, negotiating and implementing equity financing is significantly more complex and time-consuming.
- Loss of control: Many equity investors want to have a hand in directing the business. This includes occupying a seat on the company’s board. Convertible note investors, on the other hand, generally have no such expectations. This can be appealing for startups that want to retain more control.
SAFE vs. convertible note
SAFE (simple agreement for future equity) notes were first created by the startup accelerator Y Combinator in 2013. The main difference between a SAFE note and a convertible note lies in the S: “simple.”
Like convertible notes, SAFE notes are intended to be converted to equity at a later date. However, SAFE notes contain several modifications that are intended to simplify the traditional process of convertible equity financing.
Most importantly, unlike convertible notes, SAFE notes are not a loan or a debt instrument. This means that they lack a defined maturity date or interest rate. As such, there is no time pressure for the company to convert the SAFE note into equity during a fundraising round.
The considerations when it comes to SAFE notes vs. convertible notes for founders and investors include:
- Conversion event: SAFE notes automatically convert into preferred stock during the company’s next fundraising round. However, convertible notes may have a variety of possible conversion events. These include when the startup raises a given amount of money, or even when the two parties agree on the conversion.
- Speed: Due to their streamlined nature, SAFE notes are even easier to issue than convertible notes. This may be a significant benefit for businesses that want to get up and running quickly with funding.
- Investor preference: SAFE notes are increasingly popular, particularly among tech startups. However, some investors prefer to stick with convertible notes or traditional equity financing.
- Investor risk: SAFE notes lack a maturity date or interest rate, which can frustrate investors waiting to convert them into equity. In addition, if the SAFE note has a valuation cap but no discount rate, investors may not see any benefit from signing up early.
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