Convertible Notes

What is a Convertible Note?

A convertible note is a type of debt instrument that allows an investor to convert the debt into equity in the future. It is a short-term loan that is issued by a startup company to raise capital. 

The note is called "convertible" because it can be converted into equity, usually preferred stock, at a later date. Typically, the conversion happens when the company raises a subsequent round of financing, usually a Series A round.

Key Features of Convertible Note

Convertible notes have several key features that make them attractive to both investors and startups. These features include:

Conversion: Convertible notes can be converted into equity ownership in the company at a later date. This means that investors can benefit from the potential upside of the company's growth.

Maturity Date: Convertible notes have a maturity date, which is the date by which the loan must be repaid or converted into equity. This provides a clear timeline for investors and startups.

Interest Rate: Convertible notes typically have a lower interest rate than traditional debt instruments, such as bonds. This is because investors are taking on more risk by investing in a startup.

Discount Rate: Convertible notes often have a discount rate, which is the percentage discount that investors receive when they convert their notes into equity. This provides an incentive for investors to convert their notes into equity

Advantages of Convertible Note

Convertible notes have several advantages for startups and investors. These advantages include:

Flexibility: Startups can raise capital through Convertible notes without having to set a valuation for their company, and investors can benefit from the potential upside of the company's growth.

Lower Costs: Convertible notes have lower transaction costs than traditional equity financing, such as IPOs. This is because convertible notes do not require the same level of legal and accounting work.

Avoid Dilution: Convertible notes can help startups avoid dilution of their ownership stake. This is because convertible notes do not immediately convert into equity, which means that founders can maintain a larger ownership stake in the company.

Disadvantages of Convertible Note

Convertible notes also have several disadvantages for startups and investors. These disadvantages include:

Uncertainty: Convertible notes can create uncertainty for both startups and investors. Startups may not know how much equity they will have to give up in the future, and investors may not know how much their investment will be worth.

Risk: Convertible notes are riskier than traditional debt instruments, such as bonds. This is because investors are taking on more risk by investing in a startup.

Lack of Control: Convertible notes do not provide investors with the same level of control as traditional equity financing. This is because investors do not have voting rights until their notes are converted into equity.

Structuring Convertible Notes

When structuring a convertible note, there are several key terms that investors and founders need to agree upon. These terms include the valuation cap, discount rate, interest rate, and maturity date.

Valuation Cap

The valuation cap is the maximum valuation at which the convertible note will convert into equity. This means that if the company is valued at a higher price than the valuation cap at the time of conversion, the investor's equity stake will be calculated based on the valuation cap rather than the higher valuation.

Discount Rate

The discount rate is the discount that the investor receives when converting their convertible note into equity. This means that the investor will receive equity at a lower price than the price paid by later investors. The discount rate is typically between 10% and 20%.

Interest Rate

The interest rate is the rate at which the convertible note accrues interest. This means that the investor will receive interest payments on their investment until the note converts into equity. The interest rate is typically between 4% and 8%.

Maturity Date

The maturity date is the date on which the convertible note will mature. This means that the note will either convert into equity or be repaid to the investor. The maturity date is typically between 18 and 36 months.

When structuring a convertible note, it is important to balance the needs of both the investor and the founder. The terms should be fair and reasonable for both parties, and should take into account the stage of the company and the amount of risk involved. By agreeing on these key terms, investors and founders can ensure that their investment is structured in a way that is beneficial for both parties.

Frequently Asked Questions

How do convertible notes function in startup financing?

They are often used by startups that are in the early stages of development and have not yet established a valuation. Investors who provide funding through convertible notes receive a discount on the price of equity when the notes convert. This discount incentivizes investors to provide funding early on in the company's development.

What are the key differences between convertible notes and SAFEs?

SAFEs (Simple Agreement for Future Equity) are similar to convertible notes in that they are a short-term debt instrument that can be converted into equity at a later date. However, there are some key differences between the two. For example, SAFEs do not have an interest rate or maturity date, while convertible notes do. Additionally, SAFEs are typically seen as simpler and more straightforward than convertible notes.

What is the accounting treatment for convertible notes?

The accounting treatment for convertible notes can be complex and depends on the specific terms of the note. Generally, convertible notes are classified as debt until they are converted into equity. At that point, they are treated as equity on the company's balance sheet. The interest on the convertible notes is also recorded as an expense on the company's income statement.

What risks should investors consider when dealing with convertible notes?

Investors who provide funding through convertible notes should be aware of the risks involved. For example, if the company does not raise additional funding or achieve a successful exit, the convertible notes may never convert into equity, leaving investors with no return on their investment. Additionally, the terms of the convertible notes may be unfavorable to investors, such as a low valuation cap or a high interest rate.

How do convertible notes differ from traditional equity investments?

First, convertible notes are a form of debt, while equity investments involve purchasing ownership in the company. Second, convertible notes have a maturity date and interest rate, while equity investments do not. Finally, convertible notes can be converted into equity at a later date, while equity investments are ownership from the outset.

What are the specific considerations for issuing convertible notes in India?

Issuing convertible notes in India involves complying with the regulations set forth by the Reserve Bank of India (RBI). For example, the total amount of convertible notes issued by a startup cannot exceed the amount of foreign investment allowed for that industry. Additionally, the convertible notes must be issued to non-resident investors, and the funds must be received through a banking channel. Startups should consult with legal and financial professionals to ensure compliance with all applicable regulations.