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Convertible Notes – a Great Tool for Investment

February 6, 2015

So you have started your company! Maybe you have an investor or are looking for investors. How do you structure an investment to set everyone up for success? For many companies, convertible notes are the right answer.

A convertible note is a loan to your company that can convert into equity at a later date. Convertible notes have advantages:

  • Short, simple documentation.
  • Company and investor do not need to agree on the company’s valuation.
  • Simplifies capital structure when future funding rounds occur.
  • Easy for investors to understand.
  • Investors get the priority of a lender.

Here is how a convertible note can work. An investor puts $50,000 into your company. Your company gives the investor a promissory note for $50,000 that pays 8% interest and is due in 24 months. The note says that if the company later sells at least $100,000 of equity (preferred stock or common stock), then the note balance plus accrued interest will convert into the equity issued in that later “qualified round”. As a reward for investing at an early stage, the note converts into equity at a discount to what the equity investors are paying. For example, if the future investors pay $100 per preferred share, the note will convert at a 20% discount at $80 per preferred share. Convertible notes can work for both corporations and LLCs.

A convertible note might only be three pages long and be combined with a short two-page subscription agreement. You do not need to amend your articles of incorporation to issue the note. This is much simpler than convertible preferred stock documents which require 10+ pages of complex terms such as anti-dilution rights, conversion procedures, etc.

Another advantage of convertible notes is that you and the investor can agree to disagree about your company’s valuation. Let’s face it: valuing an early stage company is guesswork. You and your investor may have wildly different ideas about the value of your company. The convertible note punts the valuation discussion to the next equity round. The note investor in effect agrees to buy in at a discount to valuation used in the future equity round. The discount is often 20%, although this can be negotiated.

When you get to that future qualified round, the convertible note will convert into exactly the same sort of equity issued in that round, perhaps preferred stock. This keeps things simple because there will only be one class of investor equity. If you issue preferred stock to your initial investor and then issue a different series of preferred to future investors, you will end up with two classes of preferred stock which gets complicated quickly. And if the future investors do not like the terms of the preferred stock you issued to early investors, that can affect their decision of whether they want to invest.

Convertible notes are easy for investors to understand. The note has a principal amount, an interest rate and a due date. If the company goes bust and there is no money, then the investor and the other owners lose their investment. If there is some value, then debt (like the notes) comes before common stock (what the founders have).

Convertible notes can work for a single investor or a group of investors. Terms like interest rate and maturity date can be negotiated. The note is an obligation of the company, not the founders. So if the company goes bust the investors cannot require the founders to personally pay back the note. Even though the note has a maturity date when it must be paid back, in practice if that date is two years out the company is likely to either get additional funding or fail before the two years is up.

One important nuance is the concept of a “valuation cap”. A valuation cap protects the investor in case your company increases rapidly in value. Say the investor buys a convertible note when your company is worth next to nothing, but 18 months later you do a qualified equity round at a $5,000,000 valuation. The notes says the investor gets in that later round at a 20% discount, but that still works out to a $4,000,000 valuation which means the investor did not pick up much of the value increase from $0 to $4,000,000. Investors protect themselves by putting in a “valuation cap” which say that the highest valuation that will apply for purposes of a conversion is $X. So if an investor had a $1,000,000 valuation cap, the investor will be guaranteed a certain minimum percentage of the company. For example, a $50,000 note with a $1,000,000 valuation cap would receive 5% of the company. Without a price cap, the investor would have received only 1.25% ($50,000 / ($5,000,000 * 80%).

So if you have an investor, talk with your lawyer and other advisers about whether a convertible note might be a good fit for your situation.

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