For situations where you do not want to set an equity valuation (to not impede subsequent financings from other investors), or you simply want the option of potentially paying back the cash, for a period of time prior to taking in permanent equity capital, a convertible note is the way to go. A convertible note is a hybrid, part debt and part equity, where it functions as debt, until some point in the future, when it may convert to equity at some predefined terms. Convertible debt is typically secured from the same angel investors and venture capitalists that fund equity deals and is usually used for smaller rounds of financing at the early stages of a company’s life.
Representative Terms: A convertible note typical carries an interest rate of 4%-8% per year, which is usually paid “in kind” (grow the principal each month, not paid as cash interest). The note will typically convert into equity in the company’s next financing, typically at a 20% discount to the valuation realized in a subsequent round or with warrant coverage of 20%. The discount can be as low as a 0% discount and as high as a 50% discount, depending on the situation. The conversion valuation of the company is not fixed, however, investors often will negotiate a cap on the highest valuation their loan may be converted at regardless of the price on the next round. Being uncapped is the best position for the entrepreneur, but cannot always be achieved in the negotiation. The term of the convertible note can be as short as six months or as long as two years, depending on the needs of the company or the investor (with most in the 12-18 months range). If no following investment round is achieved during the term, the note can either auto-convert into equity at some preset terms, or be required to be repaid in cash at such time. The latter potentially being a gun to your head that could force you to sell the business at a distressed price to repay the loan. So, shoot for the former, where you can. Convertible notes can typically be repaid at anytime with cash, at 150% of the principal amount.
- Advantages: Much quicker and cheaper than issuing equity, both for legal bills (can close in weeks, not months) and ownership dilution (deferred until down the road and you can use the note proceeds to increase the value of your company). It leaves valuation flexible in order to meet the needs of subsequent investors. Interest payments do not typically need to be paid in cash each month.
- Disadvantages: You have a limited time frame before it needs to be repaid, or convert into equity.