Founders can attract early stage investment by offering a loan instrument that can convert to equity.
Big thanks to Carlos Eduardo Espinal of Seedcamp for his so easy to understand analysis of the convertible note and to Reedsy founder Emmmanuel Nataf for providing this blogger with a beautifully rendered copy of Carlos’ book, the Fundraising Field Guide.
So why would founders use a convertible note? It’s not as complex as endless blog posts make it sound but it is important to understand a convertible notes’ “moving parts”.
Investors in early stage businesses are often wary about injecting capital into a startup in exchange for equity. If the company goes bust, they will be last in line for any pay-outs due, whereas with a loan there is less downside risk – investors are more likely to recoup some of their loss.
But hey, investors want the upside too – they want to be holding equity should the company succeed. So, the convertible note starts out as a loan, but when the time is right, the loan can be converted into equity at a pre-agreed price, rather than simply paid back – meaning the investor gets to take equity in the company.
Is the convertible note really “the best of both worlds”? It certainly can be, but you do have to be careful when putting the terms of the note together.
Firstly, if you issue a convertible note for too much money, when it comes to raising your first round of equity funding, the note holder will stand to acquire a significant portion of your company. The example Carlos uses is a $300k convertible which converts as part of a $600k seed round. That means the note holder ends up with 50% of the round, and if the round is for just 20% equity in the business, new investors may be put off by the relatively small slice (10%) of the pie available.
You can get around this by creating a “qualified round” definition within the terms of the note – to ensure new investors get to secure a large enough slice of your venture you can establish roughly at the outset just how much you want to give your note holder, and try to work towards that figure.
The flipside of this is that when the terms of the convertible note are drawn up, nobody knows what size the first equity round will be, which means nobody knows the price per share. Price per share is normally calculated when the pre-money valuation is calculated – which means convertible note holders might get a much smaller slice of the pie than they thought – especially if the first round is a large one.
You can add a discount offer into the terms of the note, allowing the note holder to convert into shares at a slight discount, or you can establish a maximum pre-money valuation when you draw up the note, which ensures the note holder has a reasonable idea of what stake they are likely to receive when the note converts to equity. Typically, this would be around $4-6 million dollars.
Now, because the convertible note is a loan, it accrues interest, usually between 4-8%, Mr Espinal says in his book. This can be simply added in at the point the note is converted, which will give the note holder a few extra shares, depending on the rate.
Finally, the note may contain conversion triggers – these are specified events that will automatically trigger a conversion – typically, a round of investment, or sometimes a date at which time the note holder may either ask for their money back, or force the note to convert to equity.
So, there you have it – simple, right?
Of course it’s not, and what’s more it’s crucial too to the future of your business – get it right and it brings a happy investor and a very useful funding runway to the table – get it wrong and it could burden founders with too much debt, or too large (or too small) a stake for a by now narky investor.
We heartily recommend Carlos’ book – and one final thing – convertible notes are not compatible with EIS or SEIS schemes – you can have one or the other, but not both.