Convertible notes are one of many methods that a start-up can use to obtain investment monies for their company without having to give away equity.
What are they?
A convertible note is a promissory note that you issue to your investors. It is essentially a short-term debt for your company.
A convertible note is issued when the investors make a loan to your company. Instead of receiving shares from the get go, the investor receives a set amount of shares upon a trigger event. When the trigger event occurs, which is usually when the company is able to raise a certain amount of money, the investor is given the agreed amount of shares at a discounted rate.
Why issue a convertible note instead of shares?
Issuing shares requires you to value your company. This can be quite difficult for a start-up business as there is no history of business operations and revenue generation.
Issuing convertible notes, on the other hand, doesn’t require you to value your company. When you issue a convertible note, the investors provide you with the funds right away, but do not receive any shares until the company is able to raise a certain amount. After your company has been operating for awhile it will be much easier, to obtain a proper valuation for the company, so shares can be issued at a fair market price.
Issuing shares from the beginning means that a lot of paperwork may be involved. It is likely that your investors will want a proper shareholders agreement drafted so that their shareholdings and their rights are clearly set out. Issuing shares also requires the company to have special resolutions and provide notifications to ASIC.
In comparison, a convertible note round can be closed in a couple of days, simply by issuing a convertible note which sets out all the necessary details. An experienced start-up attorney will be able to prepare one for your company relatively quickly and will be less complicated than preparing a shareholders agreement.
You should note that while there are advantages to issue convertible notes instead of shares, it does not mean that it is the most suitable capital raising method for your business.
If you have any questions relating to the issuance of convertible notes and business structure, you should consult with a start-up attorney.
If you are unsure of the pros and cons of different capital raising methods, a good start-up attorney may be able to provide you with some professional advice. Your start-up attorney can also assist you throughout the process to ensure that you comply with all the relevant rules and regulations in relation to capital raising.