A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing. Speed, simplicity and cost.
Another significant advantage of issuing convertible notes is to avoid giving the investors any control. Convertible noteholders are rarely granted control rights and have no minority stockholder rights.
The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.
Accordingly, the cap is akin to a valuation in a priced round i. But the beauty of the cap is that it is not a valuation for tax purposes, which is why different investors may get different caps, unlike in a priced round unless there were subsequent closing sufficiently far enough apart to justify different valuations.
As Paul says in his post above :. Just like any other debt investment, senior convertible notes offer investors the ability to earn interest. Rather than cash payments, however, the interest payments typically will accrue and the amount the company owes the investor will increase over time. Both startup companies and well-established companies may opt to issue senior convertible notes to raise funds from investors.
This type of company financing has the advantage of being fairly simple to execute. This means the process of issuing the notes is relatively inexpensive for companies and it allows them quicker access to investor funding. A downside to this quick access to investor funding is that companies may end up carrying excessive debt, which could push them into insolvency or bankruptcy.
A senior convertible note is a type of convertible note. A convertible note is a debt instrument often used by angel or seed investors looking to fund an early-stage startup that has not been valued explicitly.
After more information becomes available to establish a reasonable value for the company, convertible note investors can convert the note into equity. Investors have the option to exchange their notes for a predetermined number of shares in the issuing company.
The firm valuation will usually be determined during the Series A financing round. So instead of a return in the form of principal plus interest, the investor would receive equity in the company.
If the company fails after issuing a convertible note and defaults on its obligations, its noteholders will probably be unable to get their initial seed money or investment back. Senior convertible notes have a maturity date, which is the date the notes are payable to investors if they have not already been converted to equity. The senior convertible noteholder receives two benefits not found on a normal bond issue—a call option and priority for recourse if the issuer goes bankrupt.
Due to these added benefits, the amount of interest offered to the noteholder will tend to be lower than on any other bond provided by the same issuer. From an investor's perspective, senior convertible notes can represent an opportunity to invest in the early stages of a startup with the potential to reap profits if there is a successful initial public offering IPO or acquisition. Investors who purchase senior convertible notes from an established company often are looking for an investment with a limited downside risk even if it comes at the expense of limiting upside potential as well.
One concern with early-stage companies is the possibility they will not be able to continue to raise additional rounds of equity financing after issuing a senior convertible note. Because of this, these companies may not have the money to pay back noteholders at maturity if the notes fail to convert. Some investors may require contingency stipulations to offer some protection before investing in early-stage companies that are perceived to be higher risk.
The worst-case scenario of holding a senior convertible note would be if the issuing company initially performed well, meaning that the debt would be converted into shares, and subsequently went bankrupt. The converted shares would become worthless, but the holder of the note would no longer have any recourse.
Convertible notes and convertible senior notes are a popular way for companies to borrow money with lower interest obligations than other kinds of debt. With both bank loans and convertible notes, businesses that receive financing must pay interest. Convertible notes offer several benefits. When a convertible note matures, it will automatically convert into stock shares.
Therefore, the investor will receive stock shares in your business, which essentially erases the debt. If your business is still in its early stages, though, you may want to consider it. Check out your inbox to confirm your invite. Finance All Blogs Icon Chevron. Filter by. View all results. Finance Processes. Author Jeffrey Briggs. Particularly for seed rounds, convertible notes have become the preferred fundraising instruments for many startups. But convertible notes have certain implications which can sometimes prove detrimental to startups.
Convertible Notes Are a Hybrid of Debt and Equity Convertible notes are originally structured as debt investments, but have a provision that allows the principal plus accrued interest to convert into an equity investment at a later date.
Typical terms of convertible notes are: interest rate, maturity date, conversion provisions, a conversion discount, and a valuation cap. The Pros of Convertible Notes Convertible note financings are simpler to document from a legal perspective, meaning that they are less expensive and quicker to execute. Convertible notes avoid placing a valuation on the startup, which can be useful particularly for seed stage companies which have not had enough operating history to properly set a valuation.
Convertible notes are good bridge-capital or intra-round financing options. The Cons of Convertible Notes If future equity rounds are not completed, the convertible note will remain debt and thus require redemption, potentially pushing still-fragile companies into bankruptcy. To avoid the above, terms and conditions can be set that, if taken too far, defeat the purpose of the convertible note and end up taking as much time and effort as a traditional equity round. Certain clauses such as the valuation cap and the conversion discount can complicate future equity raises by anchoring price expectations.
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