New businesses or startups don’t really have any credit history so that makes getting a conventional loan almost impossible. And the other way for a fledgling company to raise money is through equity or selling shares of the business.
But that is very difficult when there is no real way to place a value on the company and therefore the shares of the company that you are trying to sell. The solution to this dilemma is the convertible debt note.
It might seem hard to believe that something that sounds so simple could be the solution to funding any new business and that makes you want to know how does a convertible note work.
The Solution in Simple Terms
Convertible notes are an instrument that makes the loan process fair and equitable for both the borrower and the lender. The lender is giving a startup company money and in exchange for that money the company will give the lender equity ownership in the company. But the key to all of this is that the ownership equity is determined later, after the company is established and the equity holds value. This is a way for angel investors to get in on a company early and then be rewarded later with ownership.
There are two key features that set a convertible note apart from other ordinary loans. These features are the discount and the valuation cap. The discount is pretty much just what it sounds like.
This is a feature that rewards the early investors for taking the larger risk on the company.
They are offered the opportunity to obtain their shares of the company after the Series A investors have purchased theirs and they get to do this at a better rate than the Series A investors were charged. So if an investor got in on the Series A round and purchased 10 shares and paid $10,000 the holder of the convertible note would receive 12 shared for his investment of $10,000. The percentages can and do change from note to note but the principle is the same. If you invest early and take more risk than you will get a greater reward. The conversion cap also rewards the early investor for the increased risk that he or she was willing to take. The cap sets the maximum value of a company when the Series A closes which again gives the advantage to the early investors.
Benefits of Using Convertible Notes
The first benefit is obviously that the issue of valuation is not a factor with convertible notes. It eliminates the time and effort of trying to connect a value to something that really has no value yet.
It also removes the arbitrary numbers that could be projected as future value of the company. This also eliminates some of the tax issues for the startup until the value of the company can be fairly assessed. The next benefit is threefold and it encompasses the speed, simplicity and cost required to complete the process.
A basic round of convertible notes can be processed in just about a day or two and can be done with a simple two or three page promissory note. The cost for that process can be as little as $1,500 to $2,000 in legal fees. In comparison, issuing shares can take weeks just to negotiate the terms and then there are fees which can very easily exceed $25,000. One more reason that business owners like the convertible note method is that they are not forced to give up any control of the company. Standard shareholders often get seats on the board and veto rights on some corporate actions whereas the convertible noteholders are rarely granted any control rights.
Investors Who Like Convertible Notes
It takes a certain type of investor to be willing to take a chance on a new business or startup company. They need to be willing to face an increased risk factor and they need to be willing to wait to see any return on their investment. In addition to waiting to see that return they must also be willing to wait with a hands off approach. These investors tend to be the type who like being a silent partner. They have a good feeling about a company or a product that is being launched but they do not want to have any input or control of the company as it begins to grow.
What the Owner Should Consider
When you are seeking investors in your business, you will need to have a very convincing and persuasive presentation. And you will need more than simple market research to show that the public will buy your widget. Investors are more interested in your management team and their experience and know how than they are about a product or service that you will provide. They are investing in the company and the way that company is managed and run on a daily basis will determine if it is successful or a miserable failure. They will also want to be sure that your market or sector can support another business in your area. They are banking on you growing the company in a year or two to the point where it is large enough that you will be selling the first round of shares.
Then they will finally be seeing their reward. But if the industry is too small then they will never get much of a return on their investment. And their final concern is that you will use the money that they are giving you in a wise manner to grow the company. If the money is only used to get an idea off of the ground then it will most likely fail. But if you have a plan to get the business off of the ground and then use the money to continue its growth, that is when they will see their ROI. So now that you have found the answer to your question of how does a convertible note work you also should know if this is the solution you need for your business.