A convertible note is a type of debt instrument that allows the holder to convert their debt into equity at a predetermined valuation at a future round of funding. For example, let’s say you have a startup that has raised $100,000 in debt from 10 different investors. The terms of the convertible note may state that each investor has the right to convert their debt into equity at a pre-determined valuation, such as $1 million.
Interest Rate
Convertible notes typically have an interest rate associated with them. This compensates convertible note holders for taking on the risk of investing in a startup. The interest rate can be fixed or variable. Typically interest is deferred until conversion of the note into equity.
Valuation Cap
It’s important to note that a valuation cap does not impact the interest rate or maturity date of the convertible note.
Maturity Date
Another key term in a convertible note is the maturity date. This is the date the debt must be repaid unless converted to equity. Most convertible notes are short-term debt instruments (18 months or less). It’s important to negotiate this date, as it can impact the valuation of your company when it comes time for conversion.
Conversion Discount Rate
When it comes time to convert the debt into equity, the company is assigned a valuation by the investors. This is typically based on the amount of money raised, the stage of the company, and other factors. However, in some cases, the company may want to cap the valuation at a certain amount. This is known as a valuation cap.
The convertible note discount rate divides the traditional equity financing valuation by the valuation cap and subtracts that value from 1 to calculate the discount for the convertible note.
Penalties
Some convertible notes may also come with repayment penalties as well. For example, if the issuing company has a liquidation event before the maturity of the note, they may not invest in what they had hoped to be a promising company.
What is a Simple Agreement for Future Equity (SAFE)?
SAFEs were first created in 2013 by the Y Combinator startup accelerator. SAFEs were designed to provide a simpler and more flexible way for startups to raise capital from angel investors and venture capitalists. Before the creation of SAFEs, startup companies typically used convertible notes to raise money from investors. Convertible notes are debt instruments that can be converted into equity at a future date, but they were often complicated and can contain unfavorable terms for the startup company. SAFEs are intended to be simpler and more investor-friendly than convertible notes, and they have become increasingly popular among startup companies in recent years.
What are the Benefits of a SAFE
The main benefit of using a SAFE instead of other investment vehicles, such as convertible notes or warrants, is that it gives the startup more flexibility. With a convertible note or warrant, the investor gets locked into those terms, even if the company becomes a much more valuable enterprise. A SAFE, on the other hand, gives the startup the option to redeem the shares at any time for a set price. This means that if the company does well and its value increases, the investor can sell their shares at a higher price than they would have received if they had invested in Convertible Notes or Warrants.
Another advantage of using a SAFE is that it is simpler and faster to execute than other investment vehicles. There is no need to negotiate terms or draw up complicated legal documents – the SAFE agreement can be created in minutes using an online template.
SAFE Considerations
While there are many benefits to using a SAFE agreement, there are also some things to keep in mind when drafting one. First, it is important to ensure that both the startup and the investor understand and agree to all the terms of the agreement. Second, since a SAFE is essentially an unsecured loan, the startup should ensure it has enough cash reserves to cover any potential repayments if the investor decides to call in their loan. Ideally, though, when taking the note that most companies and investors expect an equity conversion, not a repayment.
Finally, it is important to remember that a SAFE is not an equity investment. While it gives the investor rights similar to common shareholders, it does not give them any ownership stake in the company.
Convertible Note Gotchas
It’s likely that when you are considering a convertible note, it’s because you don’t yet have the proof points for a traditional round of financing. Perhaps you are trying to garner more customers or a big distribution deal and you want to get either of them on the books before your next round. That all makes sense, providing you meet your goals.
If everything goes well and you raise your next round at a favorable valuation you likely will be happy with the result. However, what happens if you don’t’ meet your goals? What if you fail to raise subsequent equity financing? If you reach the maturity date and haven’t raised, you are still liable for the load and repayment terms. You could be liable for the promissory note and unpaid interest. If there’s no additional equity financing, you may have to convert at unfavorable terms.
Convertible Debt Summary
Convertible debt offers a bridge before traditional equity financing, because it can provide the company with immediate capital without having to go through the lengthy and potentially expensive process of valuing the company.
Early stage startups tend to be financed out of the pocket of the founders or by early investors or angels. Therefore, they want to make sure they can put capital to work and grow the company more quickly than without it. When the note converts, hopefully be in the situation to get the best possible valuation and minimize the impact of taking capital before they have proof points.
However, one thing to remember with Convertible Debt is that it includes a valuation cap and discount rate, which can impact the ultimate value received by the Convertible Note holder upon conversion. Therefore, it is important to carefully consider the terms and negotiate appropriately with investors.
Convertible Debt can be a good option for early stage startups looking to raise capital quickly, but it is important to understand the potential impacts on valuation before moving forward with this type of investment vehicle.
