Convertible notes allow pre-seed or seed-stage startups to raise short-term debt from investors, with the promise that this debt can be converted into equity later, usually within 18 to 24 months.
Unlike traditional bank loans, convertible notes don't require monthly interest payments, which allows startups to focus on growth without immediate repayment pressures. This blog will cover everything you need to know about convertible notes.
Convertible notes offer startups a fast way to raise money, often within days, compared to the lengthy process of securing bank loans or other financing.
They are also cost-effective, with legal fees for convertible notes ranging from $1,500 to $2,000, compared to $10,000 to $30,000 for issuing stock. This method allows startups to avoid monthly principal and interest payments, letting them concentrate on business operations.
Investors benefit from the potential upside when converting the note to equity if the startup succeeds. They often seek preferred stock, which offers advantages over common stock, such as getting their money back first in a liquidation event. Preferred stock can also come with perks like board seats, giving investors strategic influence.
Convertible notes aren't without drawbacks. Startups might end up giving away more equity than anticipated if the company achieves a high valuation. Conversely, if the startup fails to secure further funding, investors might not see any return. Understanding these risks is crucial for both parties.
Consider Emma's innovative app development startup, CodeWave. She decides to issue a $1 million convertible note to Alex, an angel investor, with a 24-month maturity, a $12 million valuation cap, a 20% discount rate, and a 10% interest rate. Over the next two years, Emma works tirelessly, and CodeWave grows significantly. When Emma is ready to raise a Series A round, the company is valued at $30 million, with shares priced at $15 each.
Alex is thrilled because his note will convert at the more favorable valuation terms. With the 10% interest on his $1 million note, the total value is $1.1 million. At a 20% discount rate, Alex could get shares at $12 each, giving him approximately 91,667 preferred shares ($1.1M/$12). Alternatively, using the valuation cap of $12 million, Alex's shares would convert at a lower price of $6 each, providing him with approximately 183,333 preferred shares ($1.1M/$6). In this scenario, the valuation cap method is more advantageous for Alex, significantly increasing his equity stake in CodeWave.
Convertible notes offer a flexible and cost-effective way to raise capital, with both benefits and risks to consider. If your startup has high growth potential, convertible notes might be a suitable option to explore for securing venture capital.
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