Imagine an entrepreneur. Though they may have a life-changing idea for a business that could take over an industry or market, they still need capital. There is not enough of a track record to generate a valuation for the company during these very early stages.
Rather than taking out a loan, entrepreneurs usually seek out seed funding. Seed funding from investors allows the entrepreneur to access the funds required to evolve their idea into a functioning and growing business. What does seed funding have to do with convertible notes? Convertible notes are one reason why investors provide seed funding.
Different Than A Loan
A loan occurs when you borrow money and then pay it back with interest. A convertible note allows you to accept money from an investor and then repay the loan or convert it into equity or shares in your company.
Convertible notes are for short-term debts and are usually issued early on in the business’s life cycle. They are simple and cost-efficient.
The Variables
Why do investors accept convertible notes? Because they are banking on your success. They expect that the equity they receive in your company will be greater than what they would get if you repaid the amount of the loan with interest. The two variables to be aware of when dealing with investors are discounts and valuation caps.
Discount speaks to the share price. After the entrepreneur receives seed funding, the next major step in raising capital will likely be Series A funding. If you issued a convertible note with no valuation cap (more on what these are in the next paragraph), you might offer a 10% discount, for example. If the price per share is $1 and someone invested $100, they would receive 110 shares upon conversion. If another person waited to invest $100 during the Series A round, they would only receive 100 shares. Think of the discount as rewarding the very early investor, who put in capital at a stage when the risk of loss is higher.
Valuation caps are another variable. It sets the maximum price at which a convertible note will convert into equity and can directly affect how much of the company the investor owns. Suppose an investor gives you $500,000 with a convertible note and a $2 million valuation cap. If Series A investors later value the company at $4 million and pay $1 per share, the convertible note will convert to equity as if the price were actually the $2 million valuation and the holder of the note will receive shares at an effective price of $0.50 per share, twice as many as Series A investors get at the same price. Again, this rewards the earlier stage investor who took on more risk.
Spitz Legal Counsel, LLC
Attorney Mark Spitz spent 15 years as both general and in-house counsel for businesses. He developed firsthand knowledge of the challenges businesses face. Allow him to take that experience and directly apply it to your company. Book a free consultation with him today to discuss your business goals.