One way to invest or fund startups is through a convertible note. This is a loan that converts into equity, so it is effectively a hybrid of debt financing and equity distribution. Convertible notes are quite popular in the startup world since they help ameliorate the challenge of startup valuation until a later point in time when the business has, hopefully, matured and there is more defined data for projected growth and profit/loss.
Important Elements of a Convertible Note
There are specific elements of convertible notes that are important to know about. They include:
- Principal: The amount of money the investor is providing to the business.
- Interest rate: This will vary from business to business, but, generally, interest on a convertible note will accrue over time and is paid either to the noteholder whenever the note is due to be repaid or convert, or is folded into the principal balance when the note conversion takes place.
- Maturity Date: This is the date that the convertible note becomes due for repayment on the request of the investor in possession of the note. Repayment dates are often between one and two years after issuance of the funds. You could also include a provision in the note stipulating that the note becomes payable only after maturity and once the majority of noteholders request issuance of repayment.
How a Convertible Note Works
If you proceed with a convertible note financing, the business receives the funds right away, but the number of shares to which the investor is entitled is determined during the next round of financing (also known as the Series A round).
Once you reach the Series A round, the business will have a more established operating history, which will help determine a reasonable price for further investment. In many instances, a convertible note will include a valuation cap. This is the threshold that triggers the note conversion.
Once the Series A investors have reached a reasonable price, or the valuation cap is triggered, the note, then converts into shares at a discounted price relative to the Series A price. This is the financial benefit for the extra risk you took by investing in the business during its fledgling period.
What Qualifies as a Reasonable Discount Rate?
The discount rate will vary from business to business. However, in many cases, the discount rate will be between 10 and 30%. In fact, 20% is one of the most common discount rates offered to convertible note holders.
However, in some situations, the discount rate may escalate as the time the convertible note has been outstanding lengthens. This may mean the investor receives a lower discount rate if the subsequent Series A financing occurs quickly, but a larger discount rate is available if funding takes more time.
Contact an Orlando Small Business Attorney
For more information on convertible note financing and the best way to structure the terms of a convertible note, contact the Chidolue Law Firm, which serves small businesses in and around Orlando, Florida.