Startup Funding Espresso -- Convertible Notes

Hello, this is Hall T. Martin with the Startup Funding Espresso -- your daily shot of startup funding and investing.

The Convertible Note is a commonly used investment structure for funding startups. It’s a short-term debt instrument that converts into equity later. If the issuer wants a debt instrument without conversion to equity, a promissory note would be a better option.

With a Convertible Note, the investor receives accruing interest while holding the note. It works well for seed-stage startups as it does not set a valuation, removes the burden of a complex equity-based term sheet, and avoids issues of dilution and taxes. It’s easy to set up compared to most equity term sheets.

A Convertible Note has three components which are the interest rate, discount rate, and cap rate:

1. The interest rate determines the annual interest that will accrue. The interest is not meant to be paid out monthly or quarterly like a bank loan but will convert to equity later along with the principal.
2. The discount rate is the amount of additional equity the investor will receive when the note converts to equity as compensation for investing early.
3. The cap rate determines how much equity the investor will receive upon conversion.

The conversion from debt to equity is usually based on a future financing round. If there is no follow-on financing round, then the note often sets a time limit (say 3 to 5 years), at which point it will convert at the cap rate.

The Convertible Note works well for investors who want to invest relatively small amounts.  Investors seeking to make large investments typically want a valuation set, board seats determined, and control provisions set which often requires an equity term sheet.


Thank you for joining us for the Startup Funding Espresso where we help startups and investors connect for funding.

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