What is a Convertible Note in Venture Capital?

What is a convertible note? Convertible notes are debt or loans given to startups by a venture capital firm. These funds are generally provided in exchange for equity shares in the company, meaning you’re investing in that company in the long run.

However, this is a loan and once you receive the funds from the venture capital firm, you must repay it within the noted time frame or immediately after that at your discretion. Below we will take a review of Convertible Notes and Venture Capital.

What Is a Convertible Note in Venture Capital?

A convertible note is financing startups and small businesses, they are used to raise capital. It is an agreement between the company and an investor, which sets the terms for a loan or line of credit. These notes are often used when a company needs money to fund its operations but has yet to prove to be successful enough to attract venture capital (VC) funding.

A convertible note can be converted into equity at some point in the future if the company meets certain milestones. This makes it attractive to investors and entrepreneurs because it provides flexibility in valuation and exit strategy.

Convertible notes are similar to equity investments in that they give investors partial ownership of the company they’re investing in. However, equity investments usually come with voting rights and more involved due diligence processes than convertible notes. Equity investors also have more control over how their investment will be used than convertible note holders.

How Does a Convertible Note Work?

Convertible notes are a type of financing used by early-stage companies. They are like loans in that they are usually repaid with interest. However, unlike traditional loans, convertible notes allow the investor to convert the debt into equity at a later date at a pre-determined price.

This is an excellent tool for investors who want to get in on the ground floor of an emerging company without taking on too much risk. Because these notes can be converted into equity, they provide additional incentives for founders to meet their goals. In short, this is how convertible notes work:

1. Convertible Notes Are Like Loans

Convertible notes are similar to loans in that you give money directly to the company and get paid back over time. The difference is that instead of receiving interest payments, you’re getting preferred stock or warrants (options to purchase preferred stock) in return. This means you can make money if the business succeeds. If the company fails, however, you may not get any money back.

2. They Are Often Used in Early-Stage Deals

Venture capitalists often use convertible notes because they allow them to invest relatively small amounts of money at an early stage of a company’s development – when it has little or no revenue – and give them more time to evaluate whether they should invest more later on.

Convertible notes also allow entrepreneurs who don’t have access to venture capital funding another option for raising capital without giving up any equity until later on down the road (or at all).

3. Convertible Notes Are Not Equity

Convertible notes are debt, not equity, which means that the investor doesn’t receive any ownership in your company or voting rights. The note converts into equity when your company receives its next round of funding from an outside investor or sells an asset for more than its value in the market.

This could happen months after the initial investment was made, but you need to know precisely when to ensure all debts are paid off before converting the note into equity.

4. Investors Get Preferred Stock if They Invest Early

The most important thing is that convertible notes are not equity. That means you can’t trade them like shares and you have no voting rights or participation in management decisions.

However, the investor does get some upside potential down the line if their investment pans out.

5. Investors Get Valuation Price (Series A and beyond)

Suppose your startup raises money at a later stage (Series A or beyond). In that case, investors can convert their notes into common stock at one of two prices:

1)     The valuation at which they invested or

2)     The valuation at which they raised their next round of funding.

This allows them to benefit from future increases in value and gives them some downside protection because they won’t end up owning any less than what they originally put in.

Advantages of a Convertible Note in Venture Capital

Venture capital is one of the most popular forms of financing for startups. While venture capital has many benefits, it also has disadvantages and drawbacks.

One of the most critical issues that a startup needs to consider while dealing with venture capitalists is the amount of equity they will get in return for the investment.

A convertible note is a financial instrument offered by venture capitalists to startups in exchange for funding their business. Convertible notes have several advantages over other forms of financing, including

1. The Exact Valuation Can Be Determined Before Investing

Startups usually face problems when they want to raise money from venture capitalists because they need to know how much equity they will get in return for their investment. This becomes particularly problematic when you want your startup’s valuation to be high to attract more investors later on.

However, if you ask for too high a valuation, your investors might not want to invest at all because they think your company needs more potential.

In such situations, convertible notes help solve this problem by allowing you to determine exactly how much equity you are going to give away before investing in your business. This helps both parties avoid potential misunderstandings when disagreements arise regarding the fair value.

2.  Founders Get To Test Ideas Without Giving up Control

Convertible notes allow entrepreneurs to test their ideas without giving up control. Entrepreneurs typically receive convertible notes instead of an outright investment because they want the freedom to exercise their judgment about how their business develops without third-party interference.

They also want more time to refine their product or service before making significant changes based on other people’s advice.

3. Sharing Risks While Sharing Rewards

Convertible notes allow investors and founders to share risks while sharing rewards. Investors take on some risk by giving up control over how a company operates, but they also stand to gain if it succeeds financially. Entrepreneurs take on some risk by giving up control over how a company operates, but they also stand to gain if the company grows economically.

4. Gives Founders Time to Prove Themselves

Convertible notes give you time to prove yourself before making a significant commitment. It’s common for startups to raise money by selling convertible notes. Why? Because they offer an opportunity for investors and founders to get to know each other before making a final decision on whether or not they want to go through with the investment.

The terms of the note typically give investors several months (or even years) before they’re required to put down their total money, allowing both parties time to evaluate their options.

5.  Founders Can Use Them As Leverage

Convertible notes can be used as leverage when negotiating future investments or acquisitions. Are you dealing with another investor or company about acquiring your company? 

Then you can use convertible notes to help you get better terms because investors know there’s no rush to close the deal right away. And they don’t want their investment to go sour if something happens.

Disadvantages of a Convertible Note in Venture Capital

Convertible notes are a popular financing tool used by investors and startups. They have several advantages over other forms of financing, including:

  • Convertible notes can be used as seed capital or later-stage capital.
  • They are simple to understand and use.
  • They are flexible to use based on the needs of the startup and investor.

However, convertible notes do have some disadvantages that must be considered before using them for your startup venture:

  • The terms of convertible notes can be complex and challenging to understand. This can lead to disputes between founders and investors. This is never good for the company or its employees.
  • Convertible notes must be converted into equity at some point – usually at the subsequent financing round. Which will dilute the ownership stake of current shareholders because new shares will be issued when a conversion occurs.

Convertible Note: a Valuable Resource

A convertible note is undoubtedly a valuable resource for an entrepreneur. Such a note has the potential to provide needed funding for startup companies during the early stages of their development without burdening them with onerous terms.

A convertible note also allows for adjustments in response to changing circumstances and is attractive since it requires little up-front investment beyond legal and accounting fees.

Are you looking for startup funding? Contact us. Peak is an early stage venture capital company.