Convertible notes are becoming increasingly common as an instrument for startups to raise their first round of investment.
The primary advantage of a convertible note over equity financing is that it doesn't require the company to be valued at the time of issue, avoiding what can be a long and expensive process.
Find out how convertible notes work, how they came to be popular for startups, the terms you need to know, and the templates that are freely available.
What are convertible notes
In an ordinary equity arrangement, an investor will give the company money in exchange for a percentage of equity (shares) in the business. For this to happen, investors and founders need to agree on a valuation for the company.
In the early stages of a companies development, there is no solid financial history, there might not be any product in the market yet and most of the value is in the minds of the founders.
Trying to decide on a company valuation when most of the company's value does not exist yet can be a difficult and expensive exercise.
Enter the Convertible Note.
A Convertible Note is a 'hybrid instrument', meaning it can switch from one type of financing to another. With a traditional convertible note, the amount of money raised exists as debt (a loan) until an agreed event triggers a right or obligation for the debt to be converted to equity.
This means the company valuation does not need to be agreed upon until this future event. The event is usually an Equity Financing round, which is when the company raises its first round of ordinary equity. The intention is that the money raised through the convertible note is used to launch the product and grow the company, taking it to a stage where it easier to agree on a valuation.
The evolution of convertible notes for startups
Y-Combinator, the first startup accelerator program, popularised the use of convertible notes as a way for startups to raise initial funds.
"The advantage of raising convertible debt is that it makes fundraising quicker. You don’t have to negotiate all the details you’d have to if you sold stock to an investor. Instead, you give them the right to buy stock in your equity round when it does happen, on whatever the terms turn out to be." - Paul Graham, Y-Combinator blog 'Announcing the Safe, a Replacement for Convertible Notes'
In late 2013, YC partner (and lawyer) Carolynn Levy created a new alternative to the convertible note, called a Safe (Simple agreement for future equity).
The Safe was designed to provide the advantage of convertible notes - not requiring a company valuation at the time of issuance - while removing the disadvantage of having debt on the company's balance sheet. Note that this was designed for the U.S. market, specifically California.
"The disadvantage of convertible debt is that although it’s only nominally debt, the law cares what things are nominally, and there are all sorts of regulations about debt. There has to be a term, which in California can’t be too long, and there has to be an interest rate not too far from market rates. The interest on convertible notes makes conversion complicated, and the fact that the debt has a fixed term causes extra work for both parties when it has to be extended." - Paul Graham, Y-Combinator blog
Under the Safe agreement, the Investment Amount is not a loan, has no set maturity or repayment date and does not accrue interest. This means that technically it's not a convertible note, however, most people refer it to as one, and so will we throughout this article.
Shortly afterwards, 500 Startups, another of the worlds largest accelerators, launched the KISS (Keep it simple security). This included a debt version and an equity version. The debt version includes an interest rate and a maturity feature, the equity version does not.
Simmonds Stewart also has free templates for the Safe and KISS agreement, adjusted for companies operating under New Zealand legislation:
We cover the key variants below. You can find more details in the article Safe vs kiss the evolution of the convertible note.
The key variables in a convertible note
When you raise money, you enter into an agreement with whoever is providing the finance. They give you money in exchange for some agreed upon terms, which are set out in a Term Sheet - this being the SAFE or KISS agreements or some other variation. The Term Sheet is a legally binding document that facilitates the exchange.
As a startup founder, it's important that you have a good understanding of terms in the Term Sheet. You will also want to have a startup lawyer to help with this process.
Here are the key terms and decisions that need to be made when issuing a convertible note:
Investment Amount or Purchase Amount
The amount of money the investor pays to the company in exchange for the convertible note. This is based on what you can agree with the investor.
The event that needs to take place to triggers the right or obligation for the Purchase Amount to be converted to equity. For a startup convertible note, this is usually an Equity Financing round, which is when the company directly sell shares for the money.
At this point, a valuation for the company is agreed and the Investment Amount of the convertible note is converted to equity at a pre-determined Conversion Price.
Determines how many shares the convertible note investor receives for the Purchase Amount.
The Conversion Price can be based on a discounted amount and/or a valuation cap.
The purpose of the discount rate and/or valuation cap is to reward the convertible note holder with a lower share price as compensation for taking on additional risk, compared to the later stage funders, by investing in the company earlier.
The price is determined by a percentage discount from the price the equity investors are paying at the Conversion Date (the date of the Conversion Event). This is usually 10-30%.
For example, a company with 1 million shares raises $100k through a convertible note with a discount of 20%.
Six months later the company raises $300,000 of seed funding (ordinary shares) at a pre-money valuation of $1.5m. The share price is calculated by dividing the value of the company by the number of shares.
Share Price for new investors = $1,500,000/1,000,000 = $1.50.
By investing $300,000 the new investors get $300,000/$1.50 = 200,000 new shares in the company.
At this point, the convertible note is triggered and the Investment Amount of $100,000 is converted to equity. The discounted applied to the share price is 20%, so the share price is $1.50*(1-0.2) = $1.20.
The number of shares that the convertible note holder gets in the company is equal to the Investment Amount divided by the discounted share price. $100,000/$1.20 = 83,333
A Valuation Cap puts a limit on the valuation of the company for the purpose of converting the shares.
Using the example above, if the convertible note was agreed to have a valuation cap of $1,000,000 instead of a discount rate, the Conversion Price would be equal to the Valuation Cap divided by the number of shares on issue.
Conversion Price = $1,000,000/1,000,000 = $1.00
In this case, the Investment Amount of $100,000 would convert to $100,000/$1 = 100,000 shares.
It is common for the Share Price to be equal to the lower the Valuation Cap or the price per share with the discount applied.
Here is an example of how this would be set out in the Term Sheet, which is taken from Simmonds Steward Kiwi SAFE convertible note template:
......a price per Share equal to the lower of:
the Valuation Cap divided by the Fully Diluted Capitalisation immediately prior to the Equity Financing; and
the price per Share at which Shares were issued to investors under the Equity Financing, less a discount of [20%]; and....
See our Cap Table Template to work out the impact of raising investment for your company, through a convertible note and subsequent equity investment.
A liquidity event means a change of control or an Initial Public Offering. The specifics of what constitutes a Liquidity Event are usually set out in the Term Sheet.
What happens in the case of a Liquidity Event is also set out in the Term Sheet. Usually, the Investment Amount converts to shares at a Valuation Cap, or the Purchase Amount is repaid.
Dissolution Event or Insolvency Event
What constitutes a dissolution event is set out in the Term Sheet, but in general it's the winding up (closure) of the company.
In this instance the Convertible noteholders will be repaid, where possible. Convertible noteholders are preferential to Ordinary Equity holders so will be paid back first, unless the company has other ordinary debt, which will be paid ahead of the convertible noteholders.
As long as there is no personal guarantee from the founders in the Term Sheet, the liability will sit with the company.
Interest Rate and Maturity Date
Interest payments and a maturity date only exist for debt based KISS convertible notes. SAFE instruments are not considered debt, so they do not have a maturity date. They are more popular for startups for this reason, because they more closely resemble Equity Financing.
If an interest rate is agreed, then all amounts will include any interest outstanding, e.g. at a Conversion Event, the amount that will be converted to shares will be the Purchase Price plus any interest outstanding.
On the maturity date, the convertible note holder can elect to convert the Purchase Amount to shares at a share price based on the Valuation Cap.
The investor may request that the Purchase Amount is repaid after the Maturity Date, instead of converting the amount to shares. Similarly, the company may repay the Purchase amount and any outstanding interest following the Maturity Date.
If you are using this form of a convertible note, make sure that you set a maturity date that gives you plenty of time to be able to raise equity financing.
Most Favoured Nation or Subsequent Instrument Clause
Sets out what happens if the company issues any more convertible notes before the Conversion Event. This is to prevent any later convertible note investors getting favourable terms to the earlier investor(s).
Usually, it requires the company to send the Investor the terms of the new offer, with the option for the Investor to exchange the terms of the initial convertible note agreement, for the terms of the Subsequent Agreement.
The drawcard for issuing a convertible note over equity is not having to agree on a valuation for the company at a time when it's hard to do.
Whether a company is able to issue convertible notes instead of equity comes down to the appetite of the investor market. Some investors want or are mandated to have the company valued before investing. Some investors are happy to go along with a faster and more cost-effective process of issuing a convertible note because it is arguably better for the company in its early stages.
As a founder, working out the best option means taking into consideration the wants and needs of your company - how much you need to raise, when and from who- and the wants and needs of the investors you're looking to raise from.
It's also important to do your homework on the types of financing instruments available, and what the terms mean. Make sure you have a comprehensive understanding of the Terms Sheet and everything you are agreeing to. It is a foundational document for your company and can have a significant impact on the prospect of your company if you get it wrong.
Speak to a startup lawyer and other founders who have raised capital before, to make sure you accurately mitigate the risks.
All the best! ✊