Convertible Note | What is it and why would you use one?

Recently, we’ve noticed quite a few Irish early stage businesses using convertible notes as the medium for their seed investment rounds. With the SEIS & EIS schemes proving to be so popular, many UK investors aren’t used to seeing this approach, so we thought we’d take the opportunity to walk through what a convertible note is and why you would use it as a option for an investment round.

What is a convertible note?

A convertible note is a short-term debt facility that converts into equity at a future date, usually pegged against a future funding round. The investor or fund is loaning the business money and instead of receiving that money back plus interest, they receive equity in the business. The outstanding balance of the loan is converted to equity at a specific milestone, usually at the valuation of a future funding round. Typically, there will be additional clauses within the convertible as incentives to the investor or fund such as discount rate, valuation cap, maturity date and interest rate.

Discount rate – The valuation discount an investor or fund receives relative to the new investors in the follow on financing round
Valuation Cap – This caps the price at which your convertible notes will convert into equity and providers convertible note holders with an additional protection to the extend the company raises its next round at a valuation which exceeds the valuation cap
Maturity Date – States the end date of the convertible note when the company has to either repay the loan or raise the follow on funding. This clause limits the time has a company has to raise its next round of funding in order to convert your loan into equity.
Interest rate – Convertible notes typically have interest as a further incentive for the investor or fund. However, as opposed to being paid back in cash, this interest can be accrued as additional principal, increasing the number of shares issued upon conversion

How does a convertible note work?

A convertible note is a type of funding option commonly used by startups and early-stage companies to raise capital.

When a company get a convertible note, it is getting debt in the form of a promissory note to investors. Unlike traditional loans where the principal amount invested by the note holder is not repaid in regular instalments. Instead, the convertible note includes a conversion feature that allows the investor to convert the outstanding balance of the note into equity in the company at a later date, typically during a future financing round or when certain conditions are met.

The terms of a convertible note typically include the interest rate, maturity date, conversion discount, and valuation cap (a maximum valuation at which the note can convert into equity). The interest earned on the note may either be payable upon maturity or convertible into equity along with the principal amount.

Convertible notes offer several advantages for both investors and companies. For investors, they provide the potential to convert their debt investment into equity at a discount to the valuation of the company in a future financing round, allowing them to participate in the company’s growth. For companies, convertible notes offer a relatively quick and straightforward way to raise capital without determining the valuation of the company, which can be challenging for early-stage startups.

When are convertible notes used?

Convertible notes are commonly used by startups and early-stage companies as a form of short-term financing to raise capital quickly.

Convertible notes are typically used in the following situations:

Early-stage financing: Startups often use convertible notes in the early stages of their development when they are still improving their business model, building a minimum viable product, or getting success in the market.
Fast growth: Companies experiencing fast growth may use convertible notes to quickly raise capital without the need for extensive negotiations or valuation discussions.
Uncertain valuation: Convertible notes are used when there is uncertainty about the company’s valuation, making it difficult to decide a fair price per share for equity financing.
Bridge financing: Convertible notes can serve as bridge financing to provide short-term funding, helping startups maintain momentum and meet immediate funding needs.
Attracting investors: Convertible notes can be attractive to investors who are interested in investing in early-stage companies but are hesitant to commit to a specific valuation.

What are the pros to convertible notes?

No valuation needed

The main pro to issuing a convertible note is that it does not force the business to set out a valuation which can often be a hugely subjective matter for pre money and early stage businesses.

Flexible structure

The structure of a convertible note is designed to benefit those investors willing to take the risk of investment before traditional valuation metrics can be applied around revenue and customers. The business can then set out a favourable discount rate for the investors at which they can convert their loan, plus accrued interest into equity at a reduced price relative to the new investors in the follow on round. Additionally, if the business set out a valuation cap on the convertible note, the investor will be able to convert their investment into equity at a preferential price per share.

Keeping it simple

Convertible notes are often faster, simpler and cheaper than traditional equity ‘priced’ rounds where actual ownership stakes are sold. Conversely, convertible notes are a form of debt, so there is no need to create a second class of shares thus avoiding complications around company valuations, stock options and tax implications.

What are the cons to convertible notes?

Lack of influence

Noteholders are at the mercy of future investors who will determine the valuation of the company. Additionally, if convertible notes are uncapped, the interests of the issuer and the noteholders are not aligned when it comes to a valuation as issuers want to the valuation to be as high as possible while noteholders want the opposite.

Rights issues

Some investors and funds prefer priced rounds as it brings with it certain rights as a shareholder such as voting rights, control rights, pro-rate rights and liquidation preferences.

What are the alternatives to convertible notes?

There are many alternatives to convertible notes for startups and early-stage companies looking for funding. These alternatives includes:

Equity financing: Startups can raise capital by selling equity shares in the company to investors. This involves selling shares of stock in exchange for investment funds, which can provide long-term capital without the need for repayment.
Revenue-based financing: In revenue-based financing, investors provide capital in exchange for a percentage of the company’s future revenue. This allows startups to access capital without giving up equity ownership or taking on debt.
Venture debt: Venture debt provides startups with debt financing, typically in the form of term loans or lines of credit. It offers a funding option that can be used to extend the company’s cash runway between equity rounds.
Grants and awards: Startups may be eligible for grants, awards, or other funding from government agencies. These funds do not require repayment or equity and can support specific projects or research initiatives.
Crowdfunding: Crowdfunding platforms allows startups to raise capital from a large number of individuals in exchange for rewards or equity. Crowdfunding can provide access to capital while also validating the product or concept in the market.

Each alternative has its advantages and considerations, and the most suitable option depends on the company’s stage of development, funding needs, growth, and long-term goals. Evaluating the pros and cons of each option can help startups make informed decisions about their financing strategy.