How do you put a price on an idea? Convertible Notes may help
- Category: Fundraising & Finance
- Date: October 28, 2020
In recent years, Convertible Notes are becoming commonplace in structuring deals for early stage start-ups as a means of raising seed funding without the increased complexity of pre-seed valuation.
Offering speed and simplicity, a growing number of start-ups are issuing Convertible Notes rather than raising more traditional equity capital.
So why are Convertible Notes so popular? Let’s take a look.
What is a Convertible Note?
Put simply, a Convertible Note (CN) is debt finance, a type of convertible security that converts into equity.
In terms of using a CN for seed funding, the debt automatically converts into shares when Series A closes. Rather than a loan from a creditor accumulating interest, a CN from an investor converts into equity based on pre-agreed terms.
A convertible note is issued to investors, typically in the very early stages of a company, in exchange for stock at a later time.Shareworks, Morgan Stanley
Why choose a convertible note over equity?
Making a cash investment for equity in early-stage (pre-seed) start-ups presents a number of challenges for an investor. CNs help to overcome these challenges, the foremost being valuation.
How do you put a price on an idea?
It’s possible, of course, but it’s not easy. A Founder’s own valuation may differ from that of a potential VC, so how do they agree on how much equity the investor should receive for their cash?
A CN helps to overcome this problem as it’s debt, not equity, meaning a valuation at this point isn’t necessary. The valuation can be agreed at Series A when far more data is available to make an accurate assessment.
This also goes someway to avoid potential issues with dilution; whereas with issuing shares the founders risk substantial dilution, with a CN there is no valuation and therefore no dilution (at least not at this moment in time).
There are a number of flexible financing options for start-ups whether raising equity finance or not, Convertible Notes are just one potential route of many.