A Convertible Note is a type of financial document, which allows companies to exchange equity or other non-tangible assets for a typically short-term loan. The Convertible Note, like a promissory note, offers something such as equity in exchange for a payment.
If you’re negotiating with investors, and they want you to quickly produce a convertible note, you can use this template. It’s modeled after the SEC’s open-source convertible note format, which is fully compliant to the Securities Act and may be registered with the SEC.
You’ll need to do all of the proper research and homework first, but this template will give you a head-start and a good framework. You should always consult a lawyer though before finalizing any contracts.
Creating a startup can be a difficult process, and you’ll definitely want to consult a lawyer. When you first begin to look for money to finance your startup, you will need to compete with other startups that are also looking for funding. Venture capital funds, angel investors, and seed rounds all might require you to have a strong foundation in the topic of convertible notes.
A convertible note is a type of financial instrument, which allows companies to define the terms for seed round investments, and investments at later stages. If the convertible note is issued at the seed round, typically the note’s conversion is going to be at the Series A financing round. The convertible note allows your company to entice investors with certain terms of financing, reducing their risk, or sweetening the reward if investors are willing to take more risk. It benefits the company most if investors put plenty of cash in during the beginning, and don’t divest for a long time, so the sweeteners in convertible notes often play to this fact.
Convertible notes contain several components that allow you to tweak the value of the notes and increase the likelihood of attracting investors. When they see the terms you are offering, you can bet that they will scrutinize these details, and make their decision based on not just the merits of the deal you are offering, but also the other potential ways they can invest. You’ll need to keep a close eye on the market and understand what other companies are doing, and what are the common criteria for convertible notes in your industry and area.
Within a convertible note, usually there are discounts stipulated. The discounts talk about the time of conversion, allowing investors to purchase stock in the company at a discount later on if they invest money in your company now. In many common cases, this discount is around 20%, which allows investors to purchase more shares than they would normally, and doesn’t typically include any interest.
Convertible notes are different than other types of investment deals because they can include incentives for investors to stick with the investment for a longer period of time. These timed discounts can help the company predict when it will receive funds in a more reliable way. Staged discounting is a very common way to “herd” investments, and spread out later divestments, increasing stability in the company.
Issuing ordinary shares, or shares of preferred stock doesn’t allow this flexibility, and this pushes the popularity of convertible notes even higher. Convertible notes also have a couple more attractive components: a valuation cap and warrants. A valuation cap is often referred to simply as a cap, and is another way to incentivize investors, by theoretically decreasing the amount per share that they would have to pay on conversion time, allowing them to buy more shares than later investors.
Warrants are defined as a percentage of the number of shares or price per share that investors will have the option to purchase at the end of the financing round when the note converts. If the convertible note warrants an extra 25%, it allows investors to purchase an additional amount of shares, worth 25% of the loan amount, at the same price of the conversion, even though the valuation may cause other shares to increase. Warrants are generally quite uncommon, as they provide very similar functionality to discounts or caps.
The last important thing to keep in mind about the different knobs and levers of a convertible note is the interest. The interest is ultimately the most secure way for investors to make money and should be paid to investors in the form of the additional value of the stock. The typical interest varies from year to year and can be anywhere from 5 up to 10%.
Similarly to the other elements of a convertible note, the interest component also applies only at the end, when the note actually converts to preferred shares of stock in the company. During the course of the loan period that the convertible note establishes, the interest is accrued. In other types of loans, such as to buy a car, the interest needs to be paid back and is compounded for the longer the term of the loan. Companies then make more money from interest if they offer loans with longer terms, because of the multiplicative factor increasing the loan amount.
With convertible notes, the interest is paid in terms of additional purchasing value for the shares. For example, if you invest $45,000 into a startup, and your interest rate was 5%, simple, not compounded interest applies. $45,000 + $45,000 *0.05 = $47,250 worth of shares that you can purchase, at the conversion price which is stipulated in the note. Effectively, this gives investors a small amount of “free shares” that they can sell and make a profit from.
Now that you have the basics of how convertible notes work, try making your own. Our template is fully form-fillable, designed to be easy to use and convenient to customize and modify for your needs.