{"id":42351,"date":"2023-10-20T15:20:34","date_gmt":"2023-10-20T15:20:34","guid":{"rendered":"http:\/\/startupsmart.test\/2023\/10\/20\/how-do-convertible-notes-work-startupsmart\/"},"modified":"2023-10-20T15:20:34","modified_gmt":"2023-10-20T15:20:34","slug":"how-do-convertible-notes-work-startupsmart","status":"publish","type":"post","link":"https:\/\/www.startupsmart.com.au\/uncategorized\/how-do-convertible-notes-work-startupsmart\/","title":{"rendered":"How do convertible notes work? – StartupSmart"},"content":{"rendered":"
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Startups often raise their first round of capital using a convertible note structure. A convertible note is a debt\/ equity hybrid structure which, if well structured, is a flexible, simple and cost-effective way to raise a seed round.<\/i><\/p>\n

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This article gives a brief explanation on the basics of convertible notes. It\u2019s the second in a series of articles written by the<\/i> LegalVision<\/i> team on capital raising for startups.<\/i><\/p>\n

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Why use a convertible note?<\/b><\/p>\n

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Valuing an early stage startup is difficult. Negotiating a valuation with investors is time consuming and often leads to deals falling through. By raising capital through a convertible note, a startup can delay valuing the business until more data is available and the size of the raise warrants a thorough negotiation process.<\/p>\n

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Secondly, convertible notes are usually relatively simple documents. By using market standard documentation, both the startup and its investors can avoid spending large amounts of money on lawyers to draft and negotiate the documentation.<\/p>\n

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How do they work?<\/b><\/p>\n

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If an investor uses a convertible note to invest in a startup, the startup immediately receives the funds; however, the number of shares the investor will be entitled to will only become clear when a pre-determined trigger occurs (usually the raising of a \u2018Series A\u2019 round).<\/p>\n

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The idea is that, by then, the startup will have some traction and the venture capitalists leading the Series A round will be in a better position to negotiate the valuation. Once the Series A pre-money valuation has been negotiated, the convertible note will convert into equity at a pre-determined discount to the Series A valuation as compensation for the additional risk taken on by the convertible note holders.<\/p>\n

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It\u2019s important to note that until the convertible note converts into equity, it is classified as debt.<\/p>\n

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How much equity will an investor receive for the convertible note?<\/b><\/p>\n

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This really depends on the price of the Series A round, as well as two other factors:<\/p>\n