They say fundraising is the rocket fuel for an emerging company, and securing investors early on is important for long-term success. So, understanding convertible notes and how to properly negotiate them is an important part of the fundraising process.
Convertible notes are a popular financing instrument for startups that allows for the flexibility of debt while also providing an option for conversion to equity. When raising capital, it's important to understand the terms of the convertible note in order to negotiate favorable terms for both the issuer and the investor. In this article, I will define what a convertible note is and provide an overview of the key terms to understand.
What is a Convertible Note?
A convertible note is a debt instrument that can be converted into equity at a later date. In other words, an investor provides a loan to a company, with the intention of converting that debt into equity when certain conditions are met, such as the next round of equity financing or a sale of the company.
The terms of a convertible note are negotiated between the issuer and the investor and will specify the conversion price, the interest rate, the maturity date, and other key terms.
What are the Key Terms to Understand in a Convertible Note?
Conversion Price: The conversion price is the price at which the convertible note converts into equity. The conversion price is often set as a discount to the price of the next equity round or a valuation cap, which sets a maximum price at which the conversion can occur.
Interest Rate: The interest rate is the rate at which the convertible note accrues interest. The interest rate can be fixed or variable and will have an impact on the cost of the convertible note.
Maturity Date: The maturity date is the date on which the convertible note must be repaid, either by conversion into equity or by repayment of the principal and interest. The maturity date is a crucial term to negotiate, as it can impact the company's financial stability and ability to raise future financing.
Discount Rate: The discount rate is the rate at which the convertible note will convert into equity at a discount to the price paid by the next equity investors. The discount rate is often negotiated as a way to incentivize early investors and compensate them for the risk of investing in a startup.
Valuation Cap: The valuation cap is the maximum valuation at which the convertible note will convert into equity. The valuation cap is often negotiated to ensure that early investors are adequately compensated for the risk of investing in a startup that may see a large increase in value in a short period of time.
Prepayment Premium: The prepayment premium is the fee that the investor will receive if the convertible note is repaid early. The prepayment premium is often negotiated as a way to compensate investors for the loss of potential future returns.
Investor Rights: Convertible votes may come with certain investor rights, such as the right to receive information about the company, the right to participate in future financing rounds, or the right to appoint a board observer. These rights are important for investors to negotiate in order to protect their investment and ensure that they have a say in the future of the company.
Default Provisions: Default provisions specify the consequences of a default by the company, such as the acceleration of the convertible note, and can have a significant impact on the company's financial stability. It is important for both parties to negotiate default provisions that are fair and reasonable.
While it is not uncommon to see a convertible note for an early-stage financing round, it's important for issuers to understand the terms of the convertible note in order to negotiate. Take the time to understand the terms, and if you are running into challenges make sure you have legal counsel who can walk you through the process to ensure you are not creating a situation that you may regret in the future.