What is a Convertible Note?
A convertible note, or also called a convertible loan, is a very common instrument for investing in newly created companies or startups. Typically, it is an instrument that is used in the initial stages of a project, when estimating a valuation for the company is avoided, since at such an early stage it is most likely that the company still does not have a product, team, clients, sales and therefore, guessing a valuation of the company is almost impossible.
A very similar instrument, and also known in the startup and technology sector, is the SAFE or Simple Agreement for Future Equity for its acronym in English. This other instrument is more commonly used in the United States, since it is the document used, for example, by the most prestigious Startup accelerator in the world, Y Combinator, located in Silicon Valley. For more information about what a SAFE is, you can find out in our article dedicated to SAFEs.
Convertible notes are relatively simple and standardized documents, although each investment fund or private investor will adapt them a little to their needs and interests. It is important that the entrepreneur review the contract in details before signing it, and the most advisable thing is to hire a law firm that has experience in this type of transaction.
Cap or Valuation Cap
The Cap establishes the maximum valuation at which some investors will convert their investment into shares at the close of the next investment round. Let’s take an example, if a startup raises 500 thousand Euros to start its journey, and a cap of 2 million Euros is established, it means that even if the next round the company obtains a valuation of 10 million, the first investors will convert their investment to a valuation of 2 million, which gives them a great advantage over new investors, mainly to remunerate the additional risk they took by investing in the startup on its day 0.
Currently, the Cap usually varies a lot based on the stage, country, sector, the initial team and the type of startup that obtains the financing.
The discount has a similar function. There are Convertible Notes that have only a cap, others that have a discount, and others that have both. In short, the discount is used in such a way that the investor will have a percentage discount on the valuation at which the new investors close the round. In the event that there is a cap and discount, initial investors will convert their investment at the lower of the resulting valuation between the cap and the discount. A common discount rate is, for example, 20%.
Common Sections in a Convertible Note:
This section will include and define the parties involved in the contract with their identifying information. The most common is that on one side, there will be the private investor, investment fund, or business angel. On the other side, you will find the newly created company or startup, and the entrepreneur.
Amount and disbursement of the loan
This section of the convertible note establishes the amount of the loan and the method by which it is disbursed. In this section, it will also be important to document the currency in which the loan will be made, and it will also be important to establish the conversion method if the loan and the valuation at the time of conversion differ in currency. This can occur in the event that the investor of the next round is foreign, and makes his investment in dollars and the initial investment was in euros, for example. There will be a divergence between the two values and it is important to tie the conversion method.
Purpose of the loan
The purpose of the loan generally refers to the management and day-to-day operation of the business in question of the company in which it is going to be invested. Sometimes, this is tied to the business plan or “business plan” presented to investors. The money, therefore, cannot be used for any other cause than business management and if used inappropriately, the contract will be terminated.
The duration of the convertible note is one of the important components of the contract. Since it will establish the maximum term to carry out the next round, and therefore the maximum term for the conversion of the investment into shares. If the established objectives are not achieved during this stablished timeline, the investor may require the return of the principal with the accrued interest.
Interest is one of the main aspects of convertible notes. Unlike SAFEs, which do not include the payment of interest, the convertible note includes an interest. For example 5%. This interest is generally not paid quarterly, but is instead accrued to the principal. It is important to model this aspect well in the financial model because the investor will obtain a greater participation based on the accumulated interest.
The amortization of the convertible note refers to the method of repayment of the loan. In this case, convertible notes do not establish repayment of the principal. The principal is the initial value of the loan, however, the objective of this contract is to be able to convert the investment into shares of the company. That is why they do not usually require amortization. The only case in which amortization is usually required is if the use of capital is not adequate and therefore investors may require repayment of principal as a result of non-compliance with the contract.
The capitalization of the loan refers to its conversion into shares of the company. The conversion of the loan is generally carried out by means of a capital increase in the Company by offsetting the loan plus the corresponding interest accrued. This conversion is carried out in an act prior to the financing round that gives rise to the entry of new investors.
In conclusion, a convertible note is one of the common instruments when investing in startups. Currently, convertible notes and SAFE (Simple agreement for future equity) are used interchangeably and fulfill a similar function, with the small differences that may exist between the two instruments and that we have been mentioning in the article. If you are thinking of closing your first round of financing for your startup, the ideal would be to make the investment through a convertible note. However, if possible, it is better to do it via SAFE. In addition, it is important to draw the reader’s attention to the fiscal component. A convertible note is definitely debt for the company, and if the company’s share capital is small, this can create a cause of dissolution for the company, at least in Spain. It is therefore important to look at the accounting implication of the investment at a fiscal level.