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Convertible notes often referred to as “converts,” are one of the most important securities used to fund early-stage startups. While their popularity has declined some since the introduction of SAFEs, they continue to be one of the most common types of investments raised by seed-stage companies and are often used during Series A, Series B, etc. extension rounds.

Healy Jones and Scott Orn, Kruze Consulting

Kruze knows converts

As a trusted advisor to companies that have raised billions in seed and venture capital funding, the team at Kruze Consulting knows a LOT about converts.

From how to account for a convertible note on the balance sheet to what discounts and caps do to the capitalization table, we’ve seen it all. Let’s dive in and share some of our learnings about this important security.

What is a Convertible Note?

What is a convertible note or convertible debt? Simply put, convertible notes or debt is one of the primary mechanisms that startup investors, like angels and seed funds, can invest in early-stage startups.

Essentially, in exchange for the money that the angels and seed-stage funds give the startup, they get a piece of paper called convertible debt. This convertible debt will allow them to make a little bit of interest while the note is outstanding. The note will typically mature in 20 to 24 months.

At the time of maturity, the investor will either get their money back, roll it over and extend, or convert it to equity if a new round has come in. And they set a valuation cap, which is effectively the valuation that they convert on when new money comes into the company.

Example: A very common valuation for super early-stage startups might be around a five or $10 million valuations or cap. So, say investors put in $1 million at a $5 million valuation on the cap on the convertible debt. Then a year later, the startup raises a Series A preferred round at a $20 million valuation. This investment triggers the conversion of the note into the same security that the Series A investors are getting. And, it’s excellent news for the convertible debt investors because they are going to convert their notes at a $5 million valuation. So they will own approximately 20% of the company, even though they put in only a million dollars. The angels and seed-stage funds get a ton of leverage from investments that go well and raise a future round at a much higher valuation. 

Again, convertible notes are always set to convert when that next giant slug of equity comes in, typically like a Series A preferred stock. 

A couple of things worth noting, convertible debt is generally compared against SAFE notes. Convertible debt was what everyone used for many years, and then Y Combinator and a couple of law firms came out with SAFE notes that are a little more friendly for founders. Safe notes don’t have a maturity date or interest. Therefore, the founder is not paying interest on the money while they are doing it. 

But those are only the two significant differences. Otherwise, SAFE notes and convertible debts are very close. 

If founders are working with ethical and experienced angels or seed-stage funds, they are not going to hold you hostage over the maturity date. Still, there are some not-so-great people out there sometimes, in the startup ecosystem, and so occasionally convertible debt; you have to be careful. You want to negotiate as long of a maturity date as possible. And again, there are convertible notes that are uncapped, meaning there is no kind of set valuation that they will convert. That means they will convert at the next round. 

Usually, they get a slight 15 or 20% discount. However, that uncapped note is not popular with investors because the investors are giving companies their money now. Startups will then use that money to improve the company, generate sales, and build a product. In the future, that company will raise funds at a much higher valuation than it could have received. The investors get penalized for that. So, often, investors will push back on uncapped convertible notes. They want that cap in there; they want to know what they convert. 

We do not typically recommend doing too many different convertible debt rounds. It is nice to get that conversion to happen into preferred equity. Get your cap table cleaned up, get it set. That way, founders know exactly how much ownership they have. Investors will also want to know what that ownership looks like as well. Plus, if you have multiple discounts and caps calculating, understanding, and articulating your capitalization table to your investors - and prospective investors - becomes very challenging. 

So again, convertible debt is typically faster and cheaper than a preferred round, and so that’s one of the reasons that super early-stage founders like to use it. And if you have any other questions on convertible debt, feel free to contact us.

Convertible Notes vs Convertible Debt 

Founders often ask us to explain the difference between convertible notes and convertible debt. The short answer is that convertible notes and convertible debt are interchangeable terms. They really mean the same thing.

Public Company Convertible Notes- How Does a Convert Differ for a Public Company vs. a Startup?

There are times when public companies will be more apt to issue convertible notes rather than stocks. When public companies feel that their shares are trading below value, typically during a downturn, they will give a convertible note because it pays less interest. The terms and features of these notes are rather different than the ones used by early-stage investors, although the basic concepts are similar. 

This will offset the value of allowing investors to convert their stocks into money and saves the company money. 

While shares are trading at lower prices, companies may decide that convertible bonds are the way to go. This way, they will avoid complex agreements with bondholders accompanying conventional debt offerings.

What are Typical Convertible Note Terms?

Convertible notes are a very popular way to raise capital, especially with angel investors. Investors will usually share a term sheet prior to the serious legal part of signing a deal with a startup. The convertible note term sheet is basically a negotiating tool to determine the main terms of the deal, and so startup founders who are raising capital should make sure they are getting standard deal terms (we always recommend working with a top startup law firm!)The convertible debt term sheet should at least consider these points:

  • Amount: What you are raising from investors.
  • Interest Rate: Convertible notes are debt and typically have a nominal interest rate, usually 2%- 5%.
  • Valuation or Conversion Cap: The valuation the investor’s note converts at:
    • Angel investors are incentivized to take the risk early on.
    • Most heavily negotiated term outside of the amount.
  • Liquidation Preference: Whether the note converts to common or preferred stock.
  • Length: Typically 18-24 months, as a founder negotiate the most extended length possible.
  • Bridge Round: After a company raises capital from an institutional investor, the inside investors will bridge the company to give them a longer cash runway; this is typically raised as convertible notes.

This is not an all-inclusive list; investors and companies may have other important items. Again, make sure you are working with an experienced lawyer who knows startup financing.

What is a Convertible Promissory Note?

  • A debt tool for investors or lenders to give a startup capital.
  • Seen most in early stages (Pre-Seed, Seed, Series A).
  • Idea is for the security to convert from debt into equity at the next funding round.
  • Typically have a conversion cap, which places a maximum valuation that the investors will pay for their shares at conversion.
  • May have a discount.
  • There are times that a convertible promissory note is used for a bridge round.
  • Straightforward tool and easy to document!

Read more about convertible promissory notes here.

How to allocate Pro-Rata correctly on Convertible Notes done in between Priced Rounds?

This is what happens when a startup defaults on a convertible note

A convertible note is one way that pre-seed or seed investors use to invest in startups that aren’t ready for valuation. The convertible notes start as short-term debt and the investors are repaid with equity in the startup, rather than principal and interest payments, once a specific milestone, like another funding round, has been reached. That’s when the startup is officially valued. 

When the convertible note comes due

Angel investors know that when they invest in a startup, the startup is going to spend that money to develop their product. But if the startup reaches the note’s maturity debt and hasn’t raised more cash, the angel investors can ask for their money back. If that money’s been spent,  there’s no way to repay the investors. 

At that point, if the startup itself has some value, the investors can join other creditors and petition for bankruptcy. There is a process that creditors can follow, and investors can use the note to exert pressure on the startup to liquidate the company. 

Extending the convertible note

Most often, angel and seed investors will just extend the convertible notes. If the startup is making progress, the founders usually ask the investors to extend the note for six months or a year so that they can do more fundraising. That’s what happens in the vast majority of cases, and it’s very rare that investors will force a bankruptcy. 

However, the possibility that investors could force bankruptcy contributed to the rise of SAFE notes (simple agreement for future equity). SAFE notes are an agreement with allows an investor to buy a specified amount of shares at an agreed-upon price at some point in the future. SAFE notes are not considered debt; they are equity, and there’s no maturity date.They’re becoming more popular for early-stage fundraising. If you have other questions on seed funding, or questions on startup accounting and tax compliance, please contact us.

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