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A common means of investing in a startup is through convertible notes. Convertible notes are relatively simple to use. This means that they may be a good option for early-stage startups that may not yet be ready to value their shares. If you plan to invest in this way, it is important to understand how the terms of a convertible note can impact your investment. This article will explain: 

  • what a convertible note is; and
  • some of the advantages and disadvantages of using them as an investor. 

What is a Convertible Note? 

A convertible note is a type of loan to a company, which can ‘convert’ into shares in that company if certain events occur. These are called ‘trigger events’.

Trigger events include the:

  • company raising another round of funding where it issues shares to its investors (i.e. equity financing);
  • company being sold or offering its shares via an Initial Public Offering (IPO) (i.e. an exit event); or
  • loan reaching its maturity date (i.e. the end of the loan).  

Convertible notes are usually used:

  • in the friends & family or angel rounds of capital raising; or 
  • as bridging finance between equity rounds. 

What Are the Benefits of Using a Convertible Note?

Flexibility

A well-drafted convertible note can give you flexibility on how your investment will be treated when the trigger event occurs.

For example, you can include a right to choose whether you will receive shares in the company (‘converting’ your note) or have your convertible note repaid in cash.

In most cases, you will want to receive shares in the company. If the company is underperforming, however, the option to have your note repaid in cash may be appealing. 

Discount Rate

You may be able to negotiate for your convertible note to convert into shares at a discount rate to the market value of those shares. This right is seen as a reward for investing early, when the business was a riskier investment. The discount means you will receive more shares for your investment.

Discounts range from 5% to over 30%, with 20% being fairly typical. 

Interest Rate

You can also negotiate for the company to pay interest on your convertible note. This interest accrues during the life of the convertible note and may be paid during this time in instalments (i.e monthly or quarterly). Alternatively, the interest can accrue over time and be repaid or converted as a lump sum when the trigger event occurs. 

Valuation Cap

You may also negotiate for the convertible note to include a valuation cap. A valuation cap is a maximum price at which your convertible note will convert into shares. Without a valuation cap, you may receive very little equity for your investment if the company’s value skyrockets. A valuation cap guarantees that you will receive a certain share of the company. 

Priority Over Shareholders if the Company Fails

Unfortunately, startups can sometimes fail. If a company fails, an external professional is appointed to deal with the company’s affairs and pay back as many creditors as the company’s remaining money allows. This process is called ‘liquidation’.

As a convertible note is a type of loan, your investment is one of these debts that the company must repay. In this instance, investing through a convertible note is more advantageous than purchasing shares outright, as equity investors (i.e. shareholders) do not receive back the money they invested to purchase the shares. Unlike equity investors, your loan may be paid back. However, the likelihood of this is still slim, as the company will typically have next to no money left.

You May Convert at Any Time

As an investor, you may request that your convertible note contains an option to convert your investment into shares at any time, rather than waiting for a trigger event to occur. Although this gives you more flexibility, it may be difficult to set a price at which the investment will convert, as there is no equity raise or exit event price to clearly link it to. 

Security

While uncommon, your convertible note can be secured by property owned by either: 

  • the company; or 
  • a guarantor (i.e. a person who agrees to be responsible for paying back the loan if needed). 

This can give you extra security. In addition, as a ‘secured creditor’, you will be paid before unsecured creditors if the company becomes insolvent and goes into liquidation. 

What Are the Disadvantages of Using a Convertible Note?

Risk of Financial Loss

Particularly in an early-stage startup, investing through convertible notes comes with a degree of risk. Unfortunately, many startups do not succeed. If the company fails and goes into liquidation while your note is outstanding, there may be no funds left to pay you and other convertible note investors after preceding debts, like bank loans, are repaid. You can attempt to reduce this risk through:

  • securing the loan over company property (intellectual or real); or
  • a personal guarantee. 

However, most startups will not agree to this. As the investor, you will have to take on the risk yourself.

Uncertainty

Investing in startups is always uncertain. However, investing using convertible notes has the additional risk that the company will not meet the trigger event. If this happens, your loan will never be repaid. As with any other investment, you should do your due diligence on the business and the founders’ capacity to make it a success. You should also seek legal advice on the terms of the convertible note. 

Lack of Control

As a convertible note-holder, you may have to forgo negotiable shareholder rights. As you are not a shareholder, you also have no voting rights. This means that you have no decision making power and less insight into the operation of the company than a shareholder or a director.

Key Takeaways

Convertible notes can be an attractive method of investing in startups. As an investor, they can give you flexibility. You can choose whether to convert your notes to shares at the trigger event or simply have your loan repaid. Convertible notes also do not need the startup to be valued, which may not make sense at an early stage. They can also come with additional benefits as a reward for your early investment in the startup, such as: 

  • interest; 
  • a discount rate; or 
  • a valuation cap. 

If you have any questions about using convertible notes to invest in a startup, contact LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.

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