Getting access to capital can help you grow your business, but it can be tricky to fundraise if your startup is still in its early stages. Many institutional investors are reluctant to put money into companies that don’t have at least some history of revenue or growth. Fortunately, you have options. One of the most common ways early-stage companies raise money is with convertible notes.
What is a convertible note?
A convertible note is a type of investment that lets founders raise money from investors without having to conduct a formal company valuation first. Unlike a priced round, which is an equity investment based on a valuation, a convertible note is a short-term debt that has the potential to convert into company equity at a later date.
Though valuations can give you a better idea of your company’s worth and growth potential, they also force you to put a price on your stock. That’s why many founders like the idea of convertible notes; you have more time to see how your company will evolve before setting a price per share.
How does a convertible note work?
If an investor believes in your company, they can give you a loan in exchange for a note in the form of convertible debt. The note then turns into shares of preferred stock upon a qualifying event or transaction, like the closing of a Series A round of financing.
Convertible notes are designed to reward early investors for their risk, which is why they typically come with a valuation cap or conversion discount.
A valuation cap sets a maximum valuation at which an investor’s money can convert into equity. This cap—which determines the company’s price per share—holds true for convertible noteholders even if later-stage investors pay a different price.
A conversion discount, on the other hand, gives investors a discount on the price per share when their note converts into equity. That means they can purchase shares of preferred stock at a lower price than investors who come in during later rounds.
If a convertible note includes a valuation cap and a conversion discount, the noteholder typically gets to choose whichever advantage gives them the lowest price per share.
Because a convertible note is a form of debt, it also comes with terms that help protect the investor, including a fixed interest rate and maturity (or expiration) date. Convertible notes typically accrue interest at a rate of 2-8%, depending on your location.
If a convertible note hasn’t already converted to equity by the time the note expires, you have to pay back your investor’s principal investment plus interest. Of course, you can always opt to extend the maturity date, but you have to get your investor’s permission to amend the note.
SAFE vs. convertible note
Many people look into SAFEs as an alternative to convertible notes. SAFEs and notes are similar in that they both convert to equity, but the process is different.
SAFE stands for Simple Agreement for Future Equity. SAFEs convert into shares of stock in a future priced round. Unlike convertible notes, which don’t convert into equity unless the company raises a specific amount of capital, SAFEs usually convert into equity during the next priced round regardless of how much money your company raises.
Another difference is that SAFEs aren’t a form of debt; they’re considered a warrant instead. Because of that, SAFEs have no maturity dates or interest rates, which can be better for founders. However, they do usually have a valuation cap or conversion discount investors can take advantage of.
Both convertible notes and SAFEs are good options for founders who want to get funds quickly. However, convertible notes tend to have more protections for investors, which can make them an easier sell.
Advantages and disadvantages of using convertible notes for financing
Like any fundraising strategy, there are pros and cons of using convertible notes to finance your company’s growth.
Advantages of convertible notes
- You save money and time. A convertible note term sheet is shorter and more straightforward than a priced round term sheet. When you don’t have to negotiate as many terms, you save time and spend less in legal fees.
- Notes are simple. You can change the terms of the note fairly easily if you need to.
- You retain control over your ownership. You don’t need a lead investor to help secure more funding.
- You may not have to conduct a valuation. If you want more time to see how your company will grow, you can hold off on a valuation until the next round of fundraising.
- Notes appeal to investors. Investors may be more willing to take a risk on your company because they’re protected by the note’s valuation cap or conversion discount.
Disadvantages of convertible notes
- You have to be careful of dilution. If you raise too much money using convertible notes, or if the notes convert at a low valuation or with a significant discount, your shares of stock as a founder may be diluted.
- You may have fewer investment opportunities. Without a lead investor to drum up interest in your company, it could be difficult to find and secure other investors.
- You could still end up doing a valuation. If you decide to use a valuation cap on your convertible notes, you will likely have to conduct some type of pre-money valuation, which could force you to put a value on your company earlier than you wanted to.
Financing your company
Fundraising for your company can be complicated, so it’s crucial to gather as much information about your options as possible. In addition to consulting your accountant and business lawyer for advice, make sure you take time to review your goals, discuss strategies with your team, and read up on the fundraising market for your industry.
Convertible notes might be a great option for you to raise money during your seed round if:
- You want to fundraise quickly.
- You want to save money in legal fees.
- You want more time to see how your company will grow before doing a valuation.
- You want to retain control over the fundraising process.
- You’re prepared to pay interest on the note.
If you like the flexibility of a convertible instrument but don’t want to deal with accrued interest on your investments, you could also consider using a SAFE instead. However, if you want a better idea of your company’s ownership and dilution, you may be more interested in the traditional path of a priced round.
No matter which route you choose, make sure you carefully weigh your options to figure out what makes the most sense for your company’s immediate and long-term growth. A Fundbox line of credit may also be a useful source of short-term capital for growth or peace of mind.
Disclaimer: Fundbox and its affiliates do not provide financial, legal or accounting advice. This content has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial, legal or accounting advice. You should consult your own financial, legal or accounting advisors before engaging in any transaction.