In recent years, investors have increasingly preferred convertible notes over SAFEs as a way to invest in startups. As a hybrid of debt and equity, convertible notes offer investors a number of advantages that SAFEs do not. But what are they, and how do they work? This article will cover some of the basics of convertible notes.
What Are Convertible Notes?
Convertible notes are debt instruments that allow the principal and any accrued interest to convert into equity at a later date. While convertible notes sometimes convert automatically, in most cases, they convert upon a conversion event (this is typically a financing or other liquidation event). Important provisions for investors include the terms and conditions of the conversion discount, the valuation cap, the interest rate, and the procedure for conversion.
What are these provisions about?
- Conversion discount. The conversion discount is the reduction in the price per share upon conversion. For example, say that a startup offers an investor a 30% discount. If its shares are valued at $5.00 per share in the next equity financing round, then the convertible note converts into equity at $3.50 per share.
- Valuation cap. The valuation cap puts a limit on the valuation of a startup upon a conversion event. In an up round, investors would get more equity than what their investment would otherwise convert to.
- Interest rate. Interest does not need to be paid for in set intervals, but is instead accrued. The accrued interest is added to the principal when determining the amount of equity an investor receives upon a conversion event.
- Procedure for conversion. In most cases, a convertible note will convert into equity when the amount of capital raised in next equity financing round reaches a pre-determined target. If this target isn’t met, then the convertible note will convert at the maturity date.
What Are the Advantages to Investors?
Convertible notes offer more financial protection to investors than SAFEs.
- If a SAFE does not convert, then investors will never acquire equity in a startup, and in the event of bankruptcy, they will lose all of their investment. Additionally, SAFEs are not debt instruments, so investors do not have access to creditor protection laws. On the other hand, convertible notes require repayment to investors if a conversion event does not occur, even if this bankrupts the startup. This means that investors will be able to recoup at least some of their investment.
- Convertible notes offer a wider range of perks than SAFEs, such as accrued interest, a conversion discount, and a valuation cap. This means that investors may end up acquiring a larger share of equity in a startup with a convertible note than with a SAFE, which can be lucrative in an up round.
So far, all we’ve covered are the benefits to investors. Do convertible notes offer any benefits to startups, or are they mostly a tool for investors to get more out of entrepreneurs?
- Startups may run into cash problems between equity financing rounds, and convertible notes are a cost-effective way to raise capital in the meantime. They are short legal documents that are simple to draft, unlike the lengthy and legalese-filled documents of more complicated equity financing rounds.
- They allow startups to delay calculating their valuations. This buys time for entrepreneurs to overhaul business models and improve revenues, if needed, which can improve the success of the next equity financing round.
So, while debt instruments do come with risk, investors and startups can both benefit if they play their cards right. This requires ensuring that the terms of convertible notes are optimal for the continued growth of the business. What might this entail?
While convertible notes offer a number of advantages to their investors, they may undermine the success of the next equity financing round. If they come with steep discounts and low valuation caps, then their investors will acquire a significant amount of equity in the next round. This may put off prospective investors of the next round, who may feel somewhat unfair that they have to pay more for the same amount of equity.
Considerations for Long-Term Success
Convertible notes have risen in popularity as investors increasingly feel the need to protect themselves in a volatile startup economy. While they do offer more financial protections than SAFEs, investors should weigh their benefits against the longer-term success of their portfolio startups. In other words, convertible notes can render a startup less attractive in subsequent equity financing rounds, which can impact the continued growth of the business. Experienced investors should negotiate convertible notes carefully to optimize this balance.
