They are debt instruments that give the chance to the holder to convert them in equity (typically shares of stock) of the company that is being funded. The equity portion, discount rate, term and interest rate will depend on the conditions established in the Note.
Conversion into company shares will happen when the startup achieves a round of financing through an increase of capital. The Convertible Notes are issued generally in the Seed Stage as a way to obtain funds from Angel Investors or Venture Capital. It’s also common to use them a “bridge investment” between round of financing to cover the expenses and salaries during the process of negotiation of the next round.
What are the advantages of using Convertible Notes? Why don’t we just make a capital increase by issuing new shares and letting the investors to subscribe them?
The main reason that drives the use of Convertible Notes is to avoid ensnares negotiation about the value of the company. When the startup is in an early stage could be very difficult to value the business. This is generally because there aren’t any concrete assets; just some intangible that will acquire value once the startups begins to generate deals.
What happens in practice is that the discussion about the valuation is postponed for the future financing round, at which time there will be more elements to make a more precise appraisal. Also at that moment the investor will receive a portion of equity equivalent to the value of the investment (or credit), most of the times with a discount (normally around a 20%) as a price for the greater risk that he decided to take at investing in an early stage of the startup.
Other provision that is commonly introduced is an interest rate over the principal. This interest can be added or not to the discount rate at the moment of the conversion to calculate the percentage of equity to give to the holder of the Note. This interest represents the financial return from the placement of money.
The Note will also have a term, commonly going from 24 to 48 months, at the end of which the investor will execute the credit asking for the capital plus the interest rate or make a forced conversion aiming to get paid with the assets of the startups at a closure of the company. This way the investor will be considered a creditor and not a shareholder in the bankruptcy process, obtaining a better position.
Other practice that is typically found in operations with Convertible Notes is the establishment of a “Valuation Cap” or “Cap”. This is also made in benefit of the investors, so in case the pre money valuation of the startup is much higher than expected, the conversion to the corresponding portion of equity will be made at the “Valuation Cap” avoiding and excess of dilution for the investors.
The normal effect of the notes is the automatic conversion at the moment of the next financing round, but there could be some other events that produce the conversion as a total o partial sell of the company or a change of control.
As for the type of stock that the Note will convert in will depend on what was agreed on the document, but is usual to grant preferred stock in Exchange of the investment.
Santiago Henriquez C., Lawyer.
Picture: Sebastian Unrau (CC0)