{"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":"
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
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What is the relationship between the discount rate and valuation cap?<\/b><\/p>\n
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Convertible notes will typically convert based on either the discount rate or valuation cap \u2013 it depends on which of the two gives the investor the higher price.<\/p>\n
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If your startup is negotiating your first convertible note, try and avoid having a valuation cap. A valuation cap can act as an anchor on your Series A pre-money valuation.<\/p>\n
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What are the interest rate and the maturity date?<\/b><\/p>\n <\/p>\n <\/p>\n What makes a good deal?<\/b><\/p>\n <\/b><\/p>\n <\/p>\n It\u2019s not always easy to work out whether the terms of a convertible note are reasonable without having some experience in startup investing. Speak to entrepreneurs and investors with experience in the convertible note space. They\u2019re not that common in Australia so make sure you speak with someone who knows what they\u2019re talking about!<\/p>\n <\/p>\n <\/em><\/strong><\/p>\n Lachlan McKnight is the CEO of LegalVision<\/em>, online law firm that provides startups and SMEs with cost-effective, fixed-fee legal advice. LegalVision has raised capital through a revenue loan structure, and Lachlan has invested in a number of startups using convertible notes<\/em>.<\/em><\/strong><\/p>\n <\/p>\n Follow<\/em> StartupSmart on Facebook, Twitter, and LinkedIn.<\/em><\/p>\n","protected":false},"excerpt":{"rendered":" Startups often raise their first round of capital using a convertible note structure. A convertible note is a debt\/ equity<\/p>\n","protected":false},"author":2,"featured_media":60384,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[10,2,20,1],"tags":[],"_links":{"self":[{"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/posts\/42351"}],"collection":[{"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/comments?post=42351"}],"version-history":[{"count":0,"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/posts\/42351\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/media\/60384"}],"wp:attachment":[{"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/media?parent=42351"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/categories?post=42351"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.startupsmart.com.au\/wp-json\/wp\/v2\/tags?post=42351"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}\n