As a startup founder, your first thought when you think of raising capital from investors may be equity investments. Equity investments are where the company issues shares to investors in exchange for those investors providing funds to the company. However, this is not the only means of raising capital. Convertible notes are an alternative way for your startup to raise funds and can have several advantages. This article explains what a convertible note is and how it can help your startup if you are raising capital.

What is a Convertible Note?

A convertible note is a loan from an investor to your company. This loan converts into equity at a later trigger event. The three common events which will trigger the conversion of the loan to equity are:

  1. the closing of a future equity investment round (this is often referred to as a ‘qualifying financing’ event);
  2. an exit event occurring, such as a business sale, an acquisition of the shares in the company or an initial public offering (IPO); and
  3. the reaching of the ‘maturity date’ of the convertible note (being the fixed date on which, if no qualifying financing or exit event has occurred, the investors can either request repayment of their investment or convert their investment into shares).

In practice, the trigger event that is most likely to occur is the closing of a future equity investment round.

At the time of conversion at the later equity round, your convertible note investors will typically receive the same class of shares as your equity investors, usually at a discounted share price as a reward for the convertible note investors’ early investment. A convertible note may also include an interest rate or valuation cap.

What Are the Benefits of Convertible Notes?

Fewer Negotiations

Convertible notes are a beneficial way of raising capital because they can allow you to get cash quickly without having to negotiate complex equity investment terms. Because investors do not receive shares upfront, you do not need to determine the company’s valuation or the rights attached to the investor’s shares. Because of this, convertible notes are often used by:

  • early stage companies who have not yet determined a company valuation; or
  • More established companies as ‘bridging finance’ between raising equity rounds.

When a company raises an equity round, the company must work out the: 

  • company’s valuation;
  • share price paid by the investors in that round;
  • number of shares each investor receives;
  • class of shares each investor receives; and 
  • terms which attach to those shares (e.g. whether investors will receive ordinary shares or preference shares). 

As investors in this case will become shareholders and be bound by the shareholders agreement, you may need to take part in lengthy negotiations about the rights they will have under the shareholders agreement and the obligations the company will have to them as shareholders. Raising capital using a convertible note bypasses a lot of these negotiations because the investors are not receiving the shares upfront.

Maintain Control and Ownership for Longer

Convertible notes can also be helpful for your startup because they allow you to maintain control and ownership of the company for longer. Because the convertible note investors do not receive their shares upfront, they do not have the voting rights that other shareholders have. It is also unlikely that convertible note investors will request a seat on the company’s board when they invest, as they do not have a direct ownership stake in the company yet. This means that, as the founder, you can:

  • retain control of the board; 
  • maintain a larger ownership stake in the company; and 
  • have fewer shareholders to answer to. 

Less Paperwork

Because convertible note investors do not receive shares upfront, you will have less paperwork to complete. 

When raising an equity round, the company will typically need:

  • shareholder or director approvals;
  • a subscription agreement setting out the terms of the investment;
  • a shareholders agreement;
  • share certificates for each investor;
  • updated internal records, including the company’s register of members; and
  • to notify the Australian Securities and Investments Commission (ASIC) of the shares that were issued to each investor.

Unlike equity investors, however, convertible note investors are not yet shareholders in the company. This means that you will need fewer documents and you will not need to notify ASIC. 

For a convertible note investment, the company needs to:

  1. consider whether the board or shareholders need to approve the issuing of the convertible notes and, if so, obtain the necessary approvals; and
  2. prepare the convertible note documents, which include the convertible note deed poll (i.e. the document setting out the terms of the investment) and a short subscription letter whereby an investor agrees to the terms of the convertible note deed poll; and
  3. update the company’s noteholders register.

You may also wish to issue your investor with a convertible note certificate, but this is optional. 

What Do I Need to Be Aware of When Raising Capital Using Convertible Notes?

Unwilling Investors

Just like you might, many investors consider raising capital to mean equity investment. Some investors, especially those who do not invest professionally or frequently, may therefore be wary of investing via a convertible note. They may feel like they are not receiving something in exchange for their investment. Some investors may also be concerned about delaying the valuation. This means that it may be more difficult to raise capital using a convertible note from certain types of investors. 

Future Plans

Although a convertible note may be an easier and quicker way to get investment compared to a drawn-out equity round, you still need to be careful about how the convertible notes fit into your future plans. Convertible notes are a form of debt. This means that, at the maturity date, the investor may request repayment of funds or conversion to equity. This conversion may occur at a challenging time for you. 

Ownership of Your Company

Additionally, the intention when using convertible notes is usually to reach a future equity investment at which point the convertible notes will convert. You should therefore be realistic about when you are likely to reach that point. You should try to avoid issuing several convertible notes before raising an equity round at a low company valuation. This could result in you giving away a lot more of your company than expected when the convertible note investors begin to convert.

Key Takeaways

If your startup is raising capital, convertible notes can be very helpful. They allow you to raise funds with less negotiation than issuing shares to investors upfront requires and maintain control and ownership of your company for longer. There is also less paperwork involved. However, convertible notes are typically used on the presumption that your company will be raising a future equity round soon, and so you will still need to carefully factor the convertible notes and their conversion into equity into your business plans. If you would like advice on the different methods of raising capital or if you need convertible note documents prepared for your startup, contact LegalVision’s capital raising team on 1300 544 755 or fill out the form on this page.

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