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What is a convertible note and how does it work?
Entrepreneurship / 26 July 2022
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Director of Entrepreneurship
Ram connects growing companies with strategic partners. He is a serial entrepreneur and business angel with over 20 years of international experience in finance and general management. Ram has coached hundreds of start-ups throughout his career. He learned from his pro-surfing career the importance of surrounding himself with passionate people and being in the right place at the right time. Ram has excellent network contacts in Tel Aviv, Israel's tech community hotspot.

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A convertible note is a hybrid financial instrument for raising funds in the very early stages of a startup typically when valuation is not set. It acts as a debt instrument until an agreed maturity period after which it can be converted to equity. The funds raised by this method would help the startup to get the ball rolling by developing its product and acquiring the early adopters. After the startup can show some positive traction, it becomes less of a challenge to assign a valuation and raise further capital.

We know that startup investing is a relatively risky proposition, and the risk is highest in the early stages of a startup. Hence these two key terms are worthwhile noting, and they incentivise the early investor for taking a higher risk:

Discount Rate (Scenario 3 below)

It is the percentage of discount applied on the share price, so the early investor gets a greater number of shares than in proportion to his investment as per the valuation. Typically, the discount ranges between 10%-25%.

Valuation Cap (Scenario 4 below)

As the name suggests, it is the maximum valuation at which the early investor agrees to value his investment regardless of the valuation at which the next funds are raised.

Another advantage of issuing a Convertible Note is that the process is faster and cheaper since it does not require going to a notary, nor does it require to issue new shares. This saves time and legal costs. Typically, the convertible notes are for 12-24 months and the option to convert it from loan to equity generally lies with the investor.

Below are four possible Scenarios as examples:

Scenario 1: StartupX does not raise funds within the maturity period – Convertible Note can be renegotiated or has to be repaid:

Convertible Note debt: $10,000

Maturity Date: 1 Year

Interest Rate: 10%

Amount payable after maturity period: $10,000 + Interest @ 10% = $11,000

Scenario 2: same StartupX raises $100,000 at a post-money valuation of $1,000,000

Assuming price per share is 1, there are 1,000,000 shares. Hence the Convertible Note issuer would receive 10,000 shares, that is 1% stake in the startup.

Scenario 3: StartupX raises $100,000 at a post-money valuation of $1,000,000. Discount for the early investor is 20%

Convertible Note debt: 10,000

Assuming the price per share is $1, there are 1,000,000 shares.

Price per share after applying discount: 1-(20%*1) = $0.8

Hence the Convertible Note issuer would receive = 10,000/0.8 = 12,500 shares, that is 1.25% stake in the startup.

As we can see in this scenario, the early investor gets 2,500 additional shares to incentivize the additional risk.

Scenario 4: Startup raises $100,000 at a post-money valuation of $1,000,000. Valuation Cap of $500,000

Convertible Note debt: 10,000

Assuming the price per share is 1, there are 1,000,000 shares.

Price of share for early investor = 500,000/1,000,000 = 0.5

Hence, he would receive 10,000/0.5 = 20,000 shares i.e., 2% stake in the startup.

As we can see in this scenario, the early investor would receive double the shares as in scenario 2 although the rest of the terms remain the same, due to the valuation cap applied.

If the valuation at which further capital is raised is lower than the valuation cap, this clause does not kick in. Negotiating with the startup, the investor may choose to include a valuation cap or discount or both.

In conclusion, convertible notes are less time-consuming, while safeguarding the investor from high levels of risk. Note: the startup must always keep in mind that if they grant too favourable terms to the early-stage investor, it could affect their equity funding round in the future, therefore consulting with the FS Entrepreneurship Centre would be advisable.

To know more about Entrepreneurship activities at FS, visit our website.

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