When startups raise money they usually go via the equity route😀. This is when a company raises seed funding by giving out equity from its business to early stage investors. Another option is the convertible note option.👓
A convertible note is a loan that an investor can give to a startup that automatically converts to shares of its stock after the companies next round of funding.
The benefits of convertible notes
Convertible notes are pretty simple and quick to setup which saves the founder and investor both money and time.✔
The other benefit of the convertible note is that it allows the company to keep hold of its stock until it reaches a good enough valuation📈 whilst still receiving capital to operate and grow.✔
Investors like convertible notes as startups will often offer to convert their convertible note investors at a discount price.✔
So what are the Cons of a convertible note?
Investors will receive the same number of shares attributed to them on their standard convertible notes regardless of the company's valuations.👀 This means if a companies value rises much higher than valuation the shares are offered to them on the convertible not they may end up getting heavily diluted when new investors inject money to the company. This is very unfair for investors who took on the most risk. To mitigate this risk investors will usually insert a conversion value cap in their convertible note terms to ensure their stocks are safe.😎🙌
A conversion value cap works by providing a max company valuation at which stocks will be sold to the convertible note investors.🏙
If the valuation at the next funding round surpasses this then the investors essentially get the shares at a discount.😊
If the valuation is less than this then the investors still win as they get more of the company for their shares.🙌
Convertible notes are therefore risky for founders as they don't set a minimum valuation price.🎈
If the company doesn't make it to its next funding round then it is stuck with a loan it must repay with interest.🎗😀