Startup Financing – Why Use Convertible Notes?

Staying on the subject of startup financing, a Convertible Promissory Note (CPN) is another vehicle that a startup can use to quickly raise capital. A CPN is a short-term debt instrument that eventually converts into equity. The debt typically automatically converts into preferred stock during a priced round (i.e., Series A). 

• To put this in another way, an investor loans money to a startup. The investor typically expects the loan to convert into equity shares and the CPN to terminate. While the terms of the CPN allow the company to repay the  principal plus interest in satisfaction of the CPN, the investor (or lender in the case of a CPN) typically invests with the intent to acquire equity upon the conclusion of a priced round. This means that the loan is not treated as purely a loan.

What Are the Advantages of Using Convertible Notes for a Startup?

• Valuation postponed. Because a CPN is not an equity instrument, as a founder, you need not ascribe a valuation to the company. Early-stage startups often do not have many metrics to base a valuation on – the startup may even be just an idea. If there is no valuation, there are no issues concerning dilution, option pricing, and founder taxes. Therefore, the valuation is postponed until the company raises additional capital through a priced round (e.g., Series A). At that time, assuming the company has begun operations, there may be many more data points to make it easier to value the startup.

• Easy, affordable, and quick. Fundraising through a CPN is quicker and more efficient than other ways to raise capital. The CPN itself can be approximately three pages in length, with only two or three terms to negotiate. This makes it possible for a CPN to be closed within a couple of days at the very least. You can expect the legal fee to be not more than $1,500 on a single CPN (along with a customary note purchase agreement) with additional subsequent CPNs costing less (economies of scale). Conversely, the issuance of preferred stock involves a degree of complexity. It can take several weeks to negotiate all the terms, and legal fees can run to $15,000 – $25,000 or more.
  
• No control by investors. When an investor receives shares of preferred stock, they are also typically granted certain control rights. These include a seat on the board and veto rights over certain corporate actions (e.g., the sale of the company). Conversely, convertible noteholders are typically not entitled to any control rights.

• Flexibility. CPNs provide greater flexibility because they make variable pricing possible. This is because valuation caps are not really valuations, making it possible to have a separate note with a different cap for each investor.

What Are the Advantages of Using Convertible Notes for an Early Investor?

When evaluating the value of a convertible note, an early investor will take the following into account:

• Discount rate. This represents the discount that the noteholder or early investor receives over the price per share at which preferred stock is priced in a subsequent priced round. The discount represents the incentive the early investor gets for the risk they take in investing early.
  
• Valuation cap. Simply put, this is a value (attributed to the company) at which a CPN will convert into equity in the future. As an illustration, if the company’s valuation is set at $2,000,000, and during the priced round the company is valued at more than $2,000,000, then the noteholder benefits from receiving shares that in the aggregate are worth more than the principal and usually even the interest put together. This is an additional reward for early investors who take on risk earlier in the life of a startup.
  
• Interest rate. A CPN will usually accrue interest. Typically, the interest is included with the principal upon conversion instead of being repaid in cash, thus entitling the noteholder to additional shares upon conversion.

How Does a Convertible Promissory Note Convert?

A CPN typically converts into preferred stock during a priced round or into common stock upon maturity. The conversion into preferred or common shares will depend on the agreed-upon terms of the CPN. The CPN usually provides for the following:

• The trigger event for conversion.
• The conversion formula.
• The converted stock.
• Any additional equity rights (e.g., pro-rata purchase rights).

What Is the Difference Between a CPN and a SAFE?

The biggest difference is that a CPN is a debt instrument that comes with an interest rate and a maturity date, whereas a SAFE does not represent a debt on the books and therefore falls within the equity category. New startups likely face resistance in their ability to raise funds using SAFEs. An investor who is new to the founder and the company (unlike family members) will usually prefer a CPN because:

• It promises a return by way of interest on a specific date or when a particular event occurs.
• In case the startup folds, a CPN holder will be paid out first, ahead of a SAFE holder.

To Sum Up: A convertible note represents an excellent way for a new startup to attract early investors.

Blog posts referenced:

(a) https://techcrunch.com/2012/04/07/convertible-note-seed-financings/

(b) https://www.seedinvest.com/blog/startup-investing/how-convertible-notes-work
(c) https://www.upcounsel.com/convertible-promissory-note