There are many ways for startups to fund their projects, and convertible notes are just one of the many. A convertible note is a short-term debt that grants the lender equity in your company when the note is due. How does this fundraising method help your business?
How Does a Convertible Note Work?
Investors can put their money in a startup in the hope of being shareholders in the future. To do that, a convertible note term sheet is applied. Investors loan money to your startup, and when the debt is due, the investor earns equity instead of getting repaid. The equity has to account for the principal loan amount and the interest on the debt.
The convertible note sheet details the agreement between the investor and the businessperson. It is not legally binding, and the parties employ other instruments such as Convertible Note Subscription Agreement and the Convertible Note Instrument, which are legally binding. As a businessperson, be sure to handle all the documents in the negotiation with keenness. You can use convertible note templates to create the documents you need for the fundraising. Before you get into the negotiations, ensure you understand the convertible note terms and details pertaining to the entire process.
Why Do You Need a Convertible Note?
A convertible note will only work if an investor trusts in the growth of your business. The debt converts into equity when one of the triggers comes to life. A conversion trigger might be something like growth of your business to accommodate the amount on the note. Another trigger is the expiration or maturity of the note. If the note is due, the debt converts into equity. When the note is due, the investor can choose to convert the amount into equity or ask to have their money back.
In case the control event changes before the conversion trigger, the investor might ask for their money back in multiples as payment. Whatever the challenges, a convertible note is an easy way to fund a startup. You can avoid making common funding mistakes that other start-up companies tend to make as well.
It is challenging to define the value of a startup. This is why most conventional lenders do not offer funding for startups. With a convertible note, investors look at the business and its probability to grow before they invest. The investor does not have to value the business, and this means there is less risk of an incorrect valuation.
Getting funding through a convertible note is a straightforward process, and you do not have to wait for long periods to get the funds to run your projects. Again, you are not offering actual ownership to the investor. You, therefore, do not have to issue common stock that brings complications in valuation, stock option grants, and valuation.
Defer Valuation Negotiations
With a convertible note, you do not have to calculate the percentage of your company you give to the investor before the negotiations. The process defers valuation process and instead allows the company to grow into a new funding stage for better valuation. This allows the parties to determine a fair price using advanced metrics.
Investors will also gain from the convertible note, seeing that the notes come with a discount rate per share. If an investor is willing to take the risk, they will pay less for every share in the future. The process also involves setting a valuation cap, which is the maximum value of the conversion price. By setting the valuation cap, convertible bondholders will receive a fixed income until their shares convert to equity. This happens even when a company becomes increasingly profitable.
Get Investors to Help You Grow
Investors take the risk of investing in a startup. Your business has to be good to attract the right investors and attract the right debt amount. Most investors choose to move with the business and help you as advisers to grow your business. This may not be part of the agreement, but investors need to know they are getting returns in the future, and they want to invest in you as much as they want to invest in your business.
Like any other funding option, you need to understand the process. Be sure to do your research so that you understand how choices might negatively or positively affect your business later on.