Startup founders can raise capital from investors through either:
- an equity round where an investor purchases ordinary or preference shares directly in the company,
- a convertible note where an investor loans money to the startup which can ‘convert’ into shares; or
- a simple agreement for future equity (SAFE).
Startups raising an early round of funding or seeking ‘bridge’ financing between two larger rounds may look to use a convertible note or a SAFE.
A convertible note or SAFE can be a simpler and faster way to get much-needed funds into the company because you can:
- delay issuing shares to an investor,
- prepare and negotiate fewer documents compared to a traditional equity round; and
- postpone agreeing on your startup’s valuation.
Although a SAFE is similar to a convertible note, it’s an equity structure whereas a convertible note is a hybrid of debt and equity. Under a convertible note, the money the investor gives the startup is considered a loan. Either the startup repays the loan, or the loan amount will convert to shares upon certain events. For example, the note ‘matures’, or the business is sold. You can read more about the differences in the article, What’s the Difference Between a SAFE and Convertible Note?
Investment and Purpose
The company issues ‘notes’ to the investor in exchange for their investment. A note usually has a ‘face value’ of $1. So, an investor who invests $100,000 will receive 100,000 notes. The investor will pay the investment amount when they sign the convertible note.
Some convertible notes may also contain a requirement that the company use the investor’s money for a particular purpose. For example, operational expenses of the company or to develop specific technology. You can negotiate this with your investor.
Sometimes, the notes will accrue interest from the day they are issued until the day they convert into shares or are repaid. The startup can pay the interest amount to the investor. But more commonly, it will just form part of the investment amount and will convert or be repaid at the same time as the original investment.
The main reason investors use convertible notes to invest in a startup is that their investment converts into shares at certain events, most commonly:
- an exit event,
- a qualifying round; and
An exit event is where the business is sold, and covers a range of different scenarios including:
- an asset sale,
- a share sale; or
- an initial public offering (IPO).
A qualifying round is an equity capital raise where the company issues shares to the investor in return for their money. Typically, for a qualifying round to be a conversion event, it must be of a particular size (e.g. a minimum of $500,000 total investment).
Maturity is a future date by which the investor expects to have either received their shares or had their money paid back. Some convertible notes will specify that the notes automatically convert into shares at maturity, while others will provide an option for either party to decide whether the investment is repaid or converted.
When a conversion event occurs, the investor receives the number of shares equal to their investment amount (including interest) at a discount. The discount is usually between 10-20%, and together with the investment amount, this is known as the conversion price.
A discount gives the investor more shares in the company than they would otherwise have if they purchased shares directly at the current share price. Its purpose is to reward the investor for backing your startup early on. The conversion price is what makes a convertible note attractive for investors.
Some investors may require the convertible note include a valuation cap. A valuation cap results in the amount invested converting into equity at a maximum price — even if the value of the company at the next capital raise is higher than that cap. For example, if the valuation cap was $1 million, but the company’s valuation at the qualifying round was $1.2 million, the amount invested would convert into equity at the $1 million valuation cap.
Using a convertible note means founders can technically delay valuing the business. At the time you need the funds, you might not have launched a product or gained market traction to help boost your valuation.
If your investor purchased shares directly at that time, they could negotiate a lower valuation. This would result in you giving away more of your company than you want. By raising under a convertible note, you’re giving yourself time to build to a more favourable valuation.
As we mentioned earlier, the maturity of the convertible note is a possible conversion event. But it can also be the date when the company must repay the investment amount if the notes haven’t yet converted into shares. The date is usually set for a few years in the future, and it’s assumed that the notes would have likely already converted into shares because of an exit event or qualifying round.
A convertible note will also set out what happens if the investor or the company commits a default event. For example, the investor can call (i.e. ask) on the company to repay the notes if it becomes insolvent. Other possible default events include:
- the company failing to pay their investor outstanding money (e.g. interest); or
- the company making an incorrect or misleading representation in the convertible note.
The convertible note will also specify the status of the notes in the event of a default. Do they rank equally with other debts of the company, such as bank loans or other convertible notes, or will others get their money back before the investor if the company goes insolvent?
Other terms a convertible note will include are:
- investor rights as a noteholder (e.g. they can’t vote at shareholder meetings if they don’t hold shares);
- confidentiality (the parties can’t disclose the convertible note arrangement to others); and
- company and investor representations and warranties (e.g. that the company is legally able to enter into the convertible note).
A convertible note remains common for startups wanting to raise capital. It’s simpler and faster than raising a traditional equity round, and allows the startup to get on with growing the business. The company can also delay bringing on board investor shareholders and setting their valuation, while the investor is rewarded with a discount.
If you are preparing your startup’s capital raise and have any questions about preparing a convertible note, get in touch with LegalVision’s startup lawyers on 1300 544 755.
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