Startup financing is a very crucial arm of a running startup, so when the startup needs funds it can explore the various options and determine which is the best fit for the startup at that time, putting into consideration the growth stage, valuation and other important factors.
A convertible note is a creative startup financing option, it more or less allows startups to access funds with flexibility on the repayment method.
So startups can either pay back with interest within the stipulated time or decide to give the investor equity in the startup.
When setting the terms of a convertible note the following are important, the price at which the fund converts into equity, the interest rate, and the maturity date.
This maturity date is when the investment is repaid with interest if it is not converted to equity. Oftentimes, the conversion happens when a conversion trigger occurs. This can be either a financing round or if the valuation has occurred.
Startups that opt for this method of startup financing are usually startups that are yet to be valued and are still in their early stage. There are various processes involved in securing a convertible note.
First, the startup and investor determine the terms and conditions on which the convertible note would operate.
This includes the investment fund, interest rate, conversion trigger, maturity date among others.
Once both parties are satisfied with the note, it is legalized by involving the necessary authorities and the note is duly signed by both parties. The investors fund the startup and the note is issued officially.
If the conversion trigger occurs, the note converts to stipulated equity for the investor, but if it doesn’t occur before the maturity date, the investment is repaid with accrued interest.
Now, these processes might vary slightly depending on the startup, the terms on which the convertible note was issued, and so on.
Sometimes, startups can request extensions of the maturity dates. However, they must ensure that parties agree to the extension and are signatories to the new agreement if that happens.
If no action is taken by the startup towards extension and they are unable to repay the investment, legal actions can be taken by the investor against them. So before deciding to source funds through convertible notes, consider several angles and factors.
One of which is the valuation cap, which determines the maximum value of the startup before a conversion can occur.
Another thing is the conversion discount, this is very important as it allows investors to convert the notes to equity at a reduced price than subsequent investors.
The maturity date should be carefully considered and decisions should be taken based on proven data to enable startups to meet up with the stipulated conditions. Other things to look out for are the investor’s rights, legal and tax implications.
Convertible notes offer various benefits to both the startup and the founder, and it is mostly easy to navigate. But there are potential demerits as well, and these can be fatal if not handled properly.
Therefore, it is advisable that all convertible note pros and cons are weighed carefully before deciding to use it as a source of startup financing.
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