How Convertible Notes Can Raise Funds for Your Business

It can be tricky to get access to capital and grow your business, especially when your business is in its early stages. Many investors are hesitant to put money into companies that do not have a history of growth or revenue. However, there are options you can consider. One of the most common ways early-stage companies raise money is with convertible notes.

What is a convertible note?

A convertible note is an investment that lets founders raise money from investors without conducting a formal company valuation first. It is a short-term debt that has the potential to convert into company equity at a later date.

Though valuations can give you a better idea of your company’s worth and growth potential, they also force you to put a price on your stock. That’s why many founders like the idea of convertible notes; you have more time to see how your company will evolve before setting a price per share.

How does a convertible note work?

If an investor believes in your company, they can give you a loan in exchange for a note in the form of convertible debt. It then turns into shares of preferred stock upon a qualifying event or transaction.

Convertible notes are designed to reward early investors for their risk which is why they come up with a conversion discount or valuation cap. A conversion discount gives investors a discount on the price per share when their note converts into equity. A valuation cap sets a maximum valuation which an investor’s money can convert into equity. It determines the price per share and holds true for convertible noteholders even if later-stage investors pay a different price.

A convertible note that has not been converted to equity by the time expires, you need to pay back your investor’s principal investment plus interest.

Advantages and disadvantages of using convertible notes for financing

There are both pros and cons of using convertible notes to finance your company’s growth.

Advantages of convertible notes

• You save money and time. A convertible note term sheet is shorter and more straightforward than a priced round term sheet. When you do not have to negotiate as many terms, you save time and spend less in legal fees.
• Notes are simple. You can change the terms of the note fairly easily if you need to.
• You retain control over your ownership. You do not need a lead investor to help secure more funding.
• You may not have to conduct a valuation. If you want more time to see how your company will grow, you can hold off on a valuation until the next round of fundraising.
• Notes appeal to investors. Investors may be more willing to take a risk on your company because they are protected by the note’s valuation cap or conversion discount.

Disadvantages of convertible notes

• You have to be careful of dilution. If you raise too much money using convertible notes, or if the notes convert at a low valuation or with a significant discount, your shares of stock as a founder may be diluted.
• You may have fewer investment opportunities. Without a lead investor to drum up interest in your company, it could be difficult to find and secure other investors.
• You could still end up doing a valuation. If you decide to use a valuation cap on your convertible notes, you will likely have to conduct some type of pre-money valuation, which could force you to put a value on your company earlier than you wanted to.

Financing your business

It can be complicated to fundraise for your company so it is important that you gather as much information as you can about the options that are available. Make sure you take time to review your goals, discuss strategies with your team and read up on the fundraising market for the type of industry you are in.

Convertible notes are a good option if you:

• Want to fundraise quickly
• Want to save money in legal fees
• Want more time to see how your company will grow before doing a valuation
• Want to retain control over the fundraising process

No matter what you choose make sure that you carefully weigh your options to determine what makes most sense for you company’s immediate and long-term growth.