Convertible notes, also known as converts, bridge loans, or convertible debts, are hybrid investment vehicles with debt- and equity-like features. A convertible note is a loan that investors make to a company that can be converted into equity (stocks) upon a triggering event, typically when the company raises its first equity round from professional angels or venture capitalists (VCs), typically from VCs.
This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”
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The loan is “converted” as if investors had literally put money in that equity round. Because investors take an early risk to invest in an unproven company, they usually receive a discount when their notes convert.
“Sometimes the notes come with warrant coverage and/or other features that are designed to provide additional benefits to the early investors,” says Riaz Karamali, partner at Sheppard Mullin Richter & Hampton LLP. [7] We’ll cover investment terms in Part 5, Term Sheet Negotiations.
Defer Valuation
With convertible notes, investors are essentially lending money to the company until an event triggers a debt-to-equity conversion. Because they are loaning money rather than investing in equities, they don’t need to determine valuation, or price per share, of the company at the time of their investment. The valuation is deferred until the company raises an A round, in which VCs come in and establish a value for the company.
In other words, angels can use convertible notes to invest now, and let the VCs do all the valuation work when they come in later. The ability to defer valuation is arguably one of the main benefits of using convertible notes. Startups, by definition, have virtually little or no sale records and financial histories, which makes them nearly impossible to value.
From Creditor to Shareholder
If a company successfully raises an A round, the entire principal amount of the angels’ notes, plus any accrued and unpaid interest, will be converted, usually at a discount, into equity. Upon conversion, they will become a stockholder instead of a creditor and thus get to enjoy the potential capital gains of owning stocks.
Similarly, the company is a “debtor” who owes the angels money until the notes are repaid, plus interest, or until the notes are converted into stocks. Once the notes are converted, the company becomes the angels’ investee instead of a debtor.
This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”
