Decoding convertible loan notes - what founders need to know

In the world of financing for growing businesses, convertible notes have emerged as a popular instrument for early-stage funding.

These financial instruments offer a blend of debt and equity characteristics that can be advantageous for both early-stage companies and investors. Understanding convertible notes is crucial for founders who seek flexible financing options that align with their company's growth trajectory.

What are convertible notes?

Convertible notes are short-term debt instruments that convert into equity, typically preferred stock, during a future financing round. They are essentially loans made to the business that can convert into shares of the company under specific conditions. This hybrid nature allows early-stage businesses to delay setting a valuation until they are more established and can command a higher price per share.

The mechanics of convertible notes

Convertible notes work by providing early-stage businesses immediate capital in exchange for the promise of future equity. The terms of a convertible note include an interest rate, a maturity date, and conversion mechanics that dictate how and when the debt will convert into equity.

Key terms associated with convertible notes include:

• Interest rate: the annual rate at which the loan accrues interest over time.
• Maturity date: the date by which the note must be repaid or converted into equity.
• Discount rate: a percentage reduction applied to the conversion price, giving note holders equity at a lower price than new investors in a future round.
• Valuation cap: a maximum valuation at which the note will convert into equity, protecting investors from excessive dilution if the company's valuation increases significantly.

Advantages of using convertible notes

For early-stage companies, convertible notes offer several benefits:

• Speed: they can be issued quickly, allowing businesses to access capital faster than through traditional equity rounds.
• Simplicity: the terms are often less complex than those of an equity round, reducing negotiation time.
• Cost-effectiveness: legal costs are typically lower since the valuation discussion is deferred.

Investors also find convertible notes appealing due to their potential for early entry into a promising growing business at a lower price, the interest that accrues on their investment, and the protection offered by valuation caps.

Potential drawbacks

Despite their benefits, convertible notes carry certain risks:

• Debt obligation: if the notes do not convert, the startup faces the pressure of repaying the debt, which can impact cash flow.
• Incentive misalignment: note holders may have different priorities than equity investors, particularly regarding company valuation and exit strategies.
• Founder dilution: upon conversion, founders may experience significant dilution of their ownership stake.

Conversion triggers and terms

Conversion triggers are events that cause the debt to convert into equity. Common triggers include a subsequent financing round, reaching a specific date, or the sale of the company. The terms of conversion, such as automatic or elective conversion, impact the timing and control over the conversion process.

Valuation caps and discounts

Valuation caps ensure that investors are not overly diluted in scenarios where the early-stage company's valuation increases substantially before the conversion. Discounts reward early investors for their risk by allowing them to convert their notes into equity at a lower price than new investors in a future financing round.

Interest rates and maturity dates

The interest rate on a convertible note is typically lower than that of a standard loan, reflecting the hybrid nature of the instrument. The maturity date provides a timeline for the startup to achieve certain milestones before the debt must be addressed, either through repayment or conversion.

Legal and tax considerations

Issuing convertible notes requires compliance with securities laws and careful consideration of investor rights. Tax implications for both the early-stage companies and investors must also be considered, as conversion events can trigger tax liabilities.

Strategic considerations for founders

Founders should weigh the timing of issuing convertible notes, the potential impact on future valuations, and the dilution of ownership. Negotiating favourable terms that provide flexibility and align with the startup's long-term goals is essential.

In summary

Convertible notes are a powerful tool for businesses seeking to balance the immediate need for capital with the desire to maintain control over equity distribution. By understanding the nuances of convertible notes, founders can strategically leverage them to fuel their company's growth while building strong relationships with early investors.

As with any financial instrument, it's important to seek professional advice to navigate the complexities and ensure the best outcome for future.