During the initial stages of a startup, it is common to resort to the issuance of convertible notes, also known as convertible loans, with the main objective of receiving a first injection of capital prior to carrying out a round of financing.
In today's article, we delve into different issues related to convertible notes and the role they play in startups.
What is a convertible note?
Convertible notes or loans are a financing instrument through which a Startup receives capital immediately by those who intend to become future investors in the company.
Thus, the startup receives this injection of capital and acquires a short-term debt agreement with the future investor who, in turn, receives preferred shares in the company.
Due to the characteristics mentioned above, convertible notes, considered a hybrid between debt (short-term) and equity (long-term), are common in the early stages of a company, when it does not have enough resources to successfully close a round of financing and, in turn, it needs funding to undertake its development plans and increase the value of the company before closing the round.
Elements of a convertible note
Although convertible notes are relatively simple documents, it is important that before the future investor disburses the agreed capital, other aspects are agreed upon, such as:
- Discount rate: This is the percentage that, at the time the funding round takes place, is applied to the valuation attributed to the company's shares. Most convertible notes issued usually include it, since it is the most efficient way to offset the risk assumed by investors as they enter the earliest stages of the project. It is common to increase the discount rate the longer the investor has lent capital to the company through convertible notes. The discount rate applied usually ranges from 10% to 35%.
- Maximum valuation to be capitalized (Cap): It consists of setting a maximum valuation at which investors who have lent capital to the company through a convertible note will be able to convert their shares in question. In cases where the discount rate and the maximum capitalization coexist, the investor will convert their shares to the value that is lower between the resulting value once the discount rate has been applied to the valuation agreed in the funding round and the value agreed as maximum capitalization.
In order to avoid future conflicts, when convertible notes are issued either at a discount rate or with a maximum valuation to be capitalized, it is important to be aware of the established values and the effects that these may have on investors and future investors of the company: when the discount rate is too high or the maximum valuation to capitalize too low, it can cause a rejection effect on those investors who consider joining the company in subsequent rounds.
- Due date: It is usually set between 12 and 24 months later, starting from the date on which the note was issued. Although this is not often the case, in cases where the next round of financing has not been completed before the established deadline, the company must repay the amount of the loan plus the interest accrued in full. Interest rate: As a general rule, it is established between 5-10% per year. Unlike the process that occurs in other common loans, the investor does not receive interest payments on a monthly basis, but these are accumulated over time until the next round of financing is carried out, thus increasing the total value of the note.
Issues to consider
- Investors will not receive shares in the company nor will they have any rights or obligations to it, until such time as the convertible notes are converted to capital, rather than those derived from their status as a creditor of the company. Convertible notes must appear as a debt on the company's balance sheet. Depending on their due date, they will be counted in the accounts of other creditors in the short term (account 521) or in the long term, as appropriate. It is important to set adequate values both for the discount rate and for the maximum valuation to be capitalized, considering that they may discourage future capital inflows. If investors or Business Angels decide to convert the notes, they will become part of the company. To prevent conflicts in the medium and long term, it is important to negotiate the minimum clauses of the future partnership agreement, before the issuance of convertible notes.
Advantages and disadvantages of a convertible note
Advantages:
- They represent less complexity and significantly lower administrative costs, compared to the issuance of common shares.
- They are financing instruments characterized by their flexibility. The company can negotiate the different conditions with each of the investors.
- It reduces the uncertainty faced by the investor, since the valuation of the company is delayed to later stages, when, as a general rule, there are greater indicators to carry out an objective valuation.
- It avoids, at first, excessive dilution of the company, since investors do not become part of the shareholding of the company.
Disadvantages:
- Misalignment of interests between investors and company founders. While entrepreneurs will be interested in closing the funding round at the highest possible valuation, the interests of investors will not always match.
- In cases where the company fails to close the funding round within the established maximum period or investors decide not to convert the notes into company shares, the company must take charge and return the loan (principal + accrued interest) to the investors.
