Issuing a convertible note is a method that can be used by a startup to obtain investment without having to give out equity upfront. A convertible note is essentially a loan the investor makes to the company to enable it to begin its operations, and upon a trigger event, instead of repaying the loan amount plus any interest to the investor, the company will issue the investor with a set amount of shares.

What is a Convertible Note?

A convertible note is a short-term debt for the company. In the initial stage of raising funds (what is often referred to as the seed round) you may seek to source capital from people you know e.g. family and friends. Instead of issuing equity in return for their investment, you can choose to issue the investor with a promissory note which contains a conversion feature which enables the company to convert the debt owed to the investor to equity. The convertible note will generally indicate:

  • the amount invested;
  • when an automatic conversion will occur (this is usually triggered when the company is able to raise a certain amount); and
  • the discount rate to be applied.

How does a Convertible Note work?

The best way to explain how a convertible note actually works in practice is by giving a very simple example.

For the purpose of this exercise, let’s suppose that Darren is starting a new company and his mate, Chris, decides to invest $30,000 into his company with the promise of shares when the company starts doing well.

The company issues Chris with a convertible note for the $30,000 that he invested. This convertible note has an automatic conversion feature at a capital raise of $150,000 with a discount rate of 25%.

Discount rates often range between 10 to 40%, with 20% being used most commonly.

When the automatic conversion feature is triggered i.e. Darren’s company is able to obtain finance of $150,000 or more from new investors, the convertible note held by Chris automatically converts to equity.

For simplicity sake, let’s say the current share price is $1.00 per share.

To reward Chris for investing early, Chris has a 25% discount. This means that Chris will be issued $30,000 worth of shares at a share price of $0.75. Chris now has 40,000 shares in Darren’s company.

At this point the convertible note that was issued by the company is now cancelled and the company no longer owes any debt to Chris.

If you are unsure of when an automatic conversion should occur and what discount rate would be appropriate for your business, you should get in touch with a startup lawyer.

What are the advantages?

By issuing a convertible note, you can avoid the difficult problem of trying to value your company prior to its operations and generation of revenue. When you issue your investors with convertible notes, your company receives the necessary funds right away but the shares do not need to be issued until you are able to raise a certain amount. It will be much easier for you, at a later date, to obtain a proper valuation for the value of the company and its shares once the company is up and running.

Issuing convertible notes may also be quicker than issuing shares as there is a lot less paperwork involved. A company can close a convertible note round in a couple of days by issuing a convertible note with all the necessary details. A good startup lawyer would be able to draft one for you relatively quickly with minimal costs to you. On the flip side, when you issue shares, you may have to enter into lengthy negotiations with the investors and if you haven’t already, you may even need to have a shareholders agreement drafted which includes the new investors. This process may be timely and costly.

In addition, by issuing convertible notes instead of issuing shares, you avoid giving the investors any control in the running of the company. The convertible note can indicate what types of shares are issued at automatic conversion, and these may be preferred shares which contain less voting rights than the ordinary shares held by you and any other founders. If no investor demands it, you don’t have to give up a board seat either. This way you can retain control of the company and it will be easier for you to make management decisions without having to run them through several different people.

However, you should note that whilst there are many advantages for startup companies to issue convertible notes, you need to ensure that you are treating your investors fairly. If you are unsure of whether or not what you are offering is fair value, you may consider seeking assistance from an experienced startup lawyer.

Conclusion

If you are unsure of whether or not issuing a convertible note is the best way to raise capital for your business, you should seek advice from a startup lawyer. Your lawyer will be able to provide you advice in regards to different methods of raising capital and assist you in determining the most appropriate method for your business.

Lachlan McKnight

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