What Are Convertible Notes and Why Use Them?

Throughout our previous entries on raising funds as a startup, we’ve been talking about raising money for your company by sharing equity with venture funds.

When you’re a company in its early days, sharing equity is difficult. Moving equity from your company to another requires a lot of time to hash out an agreement everyone can live with and it requires lawyers to work out the actual contracts. The whole process can cost upwards of $50-$100K, which is a lot of money for a company still looking for its first round of seed money.

Rather than dealing with the hassle of transferring equity, a lot of venture funds find it better to offer funding to startups using convertible notes.

Convertible notes are debts that convert into equity when a startup raises an actual equity round of funding. In essence, the venture fund offers to give you a loan of whatever amount, but instead of paying them back in actual money, the startup agrees to pay them in preferred equity. The venture fund gets the same agreement as whoever has invested in the series A round, with a bit of a discount as a good faith offer for investing earlier.

Early investing venture funds often find working with convertible notes preferrable to working with equity transfer for a few reasons:

For one, issuing a convertible note is easier. It can take weeks of discussion to transfer equity, but you can really issue a convertible note in only a couple of days. They also make it easier for the venture fund to work out the valuation of the startup by putting the discussion off until the series A round, when there is actual data to base their valuation on (rather than just a hunch). That considerably lowers the risk of their investment.

For startups, the convertible note also simplifies things. Convertible note agreements are short, maybe ten pages at most, and they can often be found online and modified according to the template.

Instead of the high cost of hiring a lawyer to transfer equity, the documents for a convertible note can often be found online. As a result, they can help generate quick funding in exchange for onle a few hundred to a thousand dollars. For a company that has limited time and financial resources, that is a tremendous advantage over complicated agreements.

Key Takeaways:

  • Convertible note are a form of debt taken on during seed funding that converts into equity when a startup begins an actual equity round of funding (usually in series A).
  • Convertible notes are preferrable to startups because they are quicker, easier, and cheaper to issue than equity. They are better for venture funds because they make valuation more flexible.
  • You can find a lot of online templates for convertible notes that you can use. Usually a lawyer is only needed in a limited capacity when working out a convertible note agreement.

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