In Short
- Conversion Events: Specify when the note will convert into equity, such as during a future funding round, on a set date, or upon an exit event like a sale or stock exchange listing.
- Interest: Determine the interest rate and payment schedule, as the note functions as debt before conversion.
- Conversion Price: Establish the price at which the note converts into equity, often including a discount to reward early investors.
Tips for Businesses
When considering a convertible note, clearly define the conversion events, interest terms, and conversion price to align with your business goals and attract suitable investors.
If your business is in its early stages, then it is likely that you will want to raise money. This can be done through raising debt or equity. Each of these methods comes with its own unique traits, but your decision will sit with your risk appetite. A convertible note is a hybrid debt/equity security that combines aspects of both debt and equity. This article will explain what a convertible note is and its key terms so you can determine if a convertible note fundraiser is right for your business.
Is Raising Debt or Equity Better?
Debt and equity both have their distinct advantages. You must assess your business’s best interest before you choose which way you want to raise money. Many businesses will employ both methods in order to diversify their risk. For example, businesses with insufficient cash flow may struggle to service the debt by meeting the interest payments. Therefore, debt financing would not be the appropriate option until cash flow improves.
What is a Convertible Note?
A convertible note is a hybrid security that has characteristics of both a debt security and equity. As the name suggests a convertible note starts as a debt security but is converted into equity in the future. This means that the investor obtains interest until such point the instrument converts. It is a popular instrument for investors as it means that they either receive a steady cash flow (from interest) until they exercise the convertible option and benefit from the characteristics of an equity investment.
Continue reading this article below the formWhat Are the Key Terms of a Convertible Note?
Conversion Events
At a certain point a convertible note will convert into equity. The conversion event term will establish when this occurs. For example this could occur during a further funding round or at a certain date. It could also happen during an exit event. An exit event is when the business is sold or listed on a stock exchange.
Interest
As a convertible note acts as a debt security before it converts, an interest term needs to be included. This will determine how much interest the business needs to pay and how often it is payable.
Conversion Price
The conversion price is the price at which the convertible note converts into equity. When a convertible note converts, an investor will receive shares that are equal to their investment amount. In addition, they will often receive a discount. The discount may be anywhere between 10-20% and is a reward to investors for putting money into a business early on.
Valuation Cap
A valuation cap puts a cap on the amount that a business can be valued for when a convertible note converts into equity. This allows investors to receive a higher amount of shares for their investment if the value of the company goes over the valuation cap. For example, if a business is worth $100,000 but the valuation cap is $80,000 then the investor will receive shares equivalent to their investment at the business’s valuation of $80,000.
What Are Other Securities that Businesses Issue?
SAFE
A SAFE is a simple agreement for future equity. It is similar to a convertible note, but there is no interest paid. Instead, an investor agrees that they will pay a certain amount of money to receive equity in the business at a future date. This future date is usually when a future funding round occurs. Investors may prefer SAFE agreements as they will receive a more accurate valuation of a business when a future funding round occurs.
Capital raising is a critical time for any startup. Take control of your startup’s equity with this free cap table template. It will also allow you to analyse and compare financing rounds to make the best capital raising decisions.
Key Takeaways
At the start of your business’s growth cycle it is likely that you will need to raise money through either debt or equity. Many businesses will do both or just choose one method. However, a convertible note is a hybrid instrument that takes traits from both debt and equity securities. It is a security that pays interest to the investor until such time the note converts into equity. The timing of the conversion event depends on what is agreed upon between the investor and the business but it can occur during a future funding round or during an exit event. A convertible note needs to include key terms such as when the note will convert or what the interest rate is. It should also include the conversion price. Other securities that you might want to consider for your business are simple agreements for future equity which gives an investor equity at a future date.
For legal assistance convertible notes contact LegalVision’s New Zealand corporate lawyers on 0800 005 570 or fill out the form on this page.
Frequently Asked Questions
The interest rate on a convertible note can change as long as it is agreed when the arrangement is formed.
No, there is no requirement to include a valuation cap.
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