What is Convertible notes in Startup Funding💡?

Funding is a crucial part of a startup. Especially if you are not a finance guy, it is really time taking to catch up with basics and figuring out how fundraising works. If you are an entrepreneur, it’s really important to have knowledge that can help your company grow exponentially 📈.

Convertible Notes are the most common and popular way to raise money from investors for an early-stage startup. After reading books 📚 and many articles, I decided to write a single article that is simple enough to understand who has started. To understand the convertible note, some important concepts need to be cleared, like

EQUITY

A company’s ownership is divided into small chunks which are known as Stocks or Equity. Basically, Stock is a certificate that you own part of a business, which gives you the power to control and share of the profit/loss.

COMPANY VALUATION

Valuation is the process to identify the worth of a company. For a tech company, valuation depends on many factors including assets, growth, market size, and more. Basically, the value of a startup is not only related to revenue but its potential 💪🏻.

A PRICED ROUND

A Priced Round is a process of raising money in exchange for Equity at the current company valuation. After agreeing to company valuation, an investor will invest money in exchange for stock. For example, the Investor will get 10% of company stocks by investing $100,000 on a post-money valuation of $1 million 💰.

Priced Round is a very complex process that, requires lots of time and effort, like negotiations, writing documents, litigation, etc. This process can take more than six months depending on the factors involved, and when you finally get money in your account.

As a startup, a priced round can be a very overwhelming and time taking process which is not affordable for such an early-stage startup. All these are efforts only because equity is involved in Priced Round, if we can eliminate equity from the equation for some time fundraising can be completed within weeks 🤩.

CONVERTIBLE NOTES

Convertible notes are a process to raise funds without equity. You will be accessing capital from investors on short-term debt by avoiding dilution, complex litigation, and negotiations. A convertible note is like a loan, but instead of mortgaging a house 🏠 or property, you are mortgaging your Stocks.

Equity is more expensive than debt

Basically, investors will give you a loan with some interest rate, and instead of getting his money back with interest, we’ll be issuing him stock after some period of time on future valuation. And for an early-stage startup, this is the best option to raise money because equity is more expensive than debt. Usually, Seed Round is ideal to raise money using convertible notes. For investors it’s the same risk as priced around because eventually, he is going to be paid by Equity, so he’ll definitely validate the growth plan.

CONVERTIBLE NOTES TO EQUITY

Ideally, convertible notes will be triggered when the triggered company is raising a new round of funding or the company is acquired. Let say after 18 months of seed round (convertible), the company is raising fund 💵 for Series A. Now there can be 3 possible scenarios,

1. Company Growth is aligned with the expectation 🙂
   If the company has grown at normal speed, then the investor will receive stocks equivalent to [Invested Amount + Interest for 18 Months] on valuation current time.
2. Company Growth is much more than expected
   In this case, after 18 months company valuation is much higher than expected because of exponential growth. So seed investors will get less amount of stock on current valuation as valuation is too high. And in this case, he will not be compensated for the amount of risk he took by investing in such an early stage. To balance this situation, Valuation CAP is defined during the seed round which allows investors to control notes even on high valuation. Valuation CAP is the maximum valuation at which the notes convert. So in this case, investors will receive equity on Valuation CAP rather than current company valuation.
3. Company Growth is lower than expectations 😞
   What if the company does not grow and not able to raise the next funding, in that case, there is a maturity date on convertible notes. For example, if the maturity date is 18 months, and the company is not able to secure the next round than investor can convert their notes with interest in equity or request payback

CONCLUSION

1. Priced Round is complex and time taking process which early-stage startup can not afford
2. For an early-stage startup, equity is much more expensive than debt.
3. Convertible Notes are short time debt that will be converted into Equity before the next round of funding or on the maturity date
4. Investors can use Valuation CAP or Maturity date depending on the scenario to get a return on their investment

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