However, it can be hard to raise capital at the beginning and find investors that are willing to place their resources into your vision. This is where the use of convertible notes can really aid your capital raising strategy. Keep reading to learn more.
What Is A Convertible Note?
A convertible note allows your business to get obtain capital without actually allocating shares to the investor immediately.
Let’s elaborate on this.
An investor will place their money into a company in exchange for the future allocation of shares. As a result, they now become stakeholders of the company – or more specifically note holders.
The appraisal of the shares will depend on how much a company is valued at. In other words, a valuation determines how much your company is worth or how much it will be worth in the future. When setting up your startup, getting the company valued can be difficult or it can result in the company being valued at much less than what is ideal.
When a convertible note is used, a startup can collect capital from their investors and allocate shares to them once the business has had time to grow and be properly valued.
So, your startup has time to get things sorted before shares are officially given out, and you don’t need to stress about losing potential investment!
How Can A Convertible Note Help Me Raise Funds?
A convertible note can be useful in raising funds as it can also be an attractive deal for investors.
As investors are taking more risk by putting money into a startup without actually knowing how much equity it will amount to, convertible notes thus help them get shares at a discounted rate.
The discounted rate is a percentage of extra shares that is agreed upon by both the investor and the owner of the startup. When the investor eventually receives their shares for the investment, the additional shares that were part of the ‘discount’ are also added to it.
Types Of Convertible Notes
There are two main types of convertible notes and they have to do with giving investors a type of guarantee or insurance if business doesn’t pan out as you had hoped it would. These are secured and unsecured convertible notes.
A secured convertible note determines that if a startup is not able to follow through on their promise and pay the equity owed to the investor, the investor will be repaid with the startup’s assets.
An unsecured convertible note is where the startup pays the investor in shares or by giving the amount of money they invested back (if they cannot give shares).
Loans As A Way To Get Funding For Your Startup
Loans are another way to get funding for your startup. If you are not looking for someone to invest in your startup in exchange for shares, then you can always go the route of taking out a loan.
Naturally, the loan will need to be paid back by a certain date or in instalments, usually with a rate of interest.
Do I Need A Convertible Note Agreement?
Yes, if you’re using convertible notes to help your startup hit the ground running, a convertible note agreement is crucial.
Getting a convertible note in place is not as simple as just giving or receiving money in exchange for shares (even if it were, we would still recommend a written agreement) but there are a lot of factors in place that should be agreed to in a signed, legal document. That way, the interests of both parties are protected.
A convertible note agreement should generally cover the following:
- Important dates regarding when the shares are due as well as when the money had been invested
- What happens if the startup is unable to follow through on their end of the deal
- The rate of the investors discount
- Cap on the conversion amount so investors don’t end up taking too much equity
- Interest rates (if applicable)
- The process in the event the startup qualifies by raising a specific amount in a certain time frame
Are Convertible Notes Debt Or Equity?
This is where the concept of convertible notes can confuse people – they are technically both debt and equity simultaneously.
Convertible notes are like a short term loan. However, they turn into equity later when the investor is allocated their shares.
Therefore, it starts off as a loan with the intention of becoming equity later on, at an agreed upon date.
What Are The Benefits Of A Convertible Note?
A convertible note is beneficial mainly as it allows you to get capital before valuing your business first.
Often, a new startup can be valued as much less, mainly because the business hasn’t had a chance to grow yet. In turn, this can make a smaller investment amount worth more in shares than they should be.
If you feel your startup is undervalued (amounting to the investment and value of shares not adding up), a convertible note could be a sensible solution to this issue.
Should I Get A Convertible Note For My Startup?
Whether a convertible note is the right thing to do for your startup will depend entirely on matters such as your current situation and future goals. If you are happy to get capital now in exchange for giving investors shares at a discounted price at a later date, then it can be a financially beneficial move for your startup.
However, if you have concerns such as whether or not you want to give up shares in your startup or doubts about the return amount for investors, then you can always look into other ways of raising capital.
What Else Should I Consider?
Raising capital is just one of the many things owners of startups need to think about. In fact, if you’re getting to business, there’s a number of legal considerations you need to think about, such as:
- Choosing the right business structure
- Registering your business
- Protecting your intellectual property
- Getting the right legal documents in place
- Managing all the various business relationships such as employees, shareholders and suppliers
If you’d like to learn more, check out our guide on Surviving The First 6 Months As A Startup.
Convertible notes can be a great way to raise capital for your startup, if it’s the right move for your venture. To summarise what we’ve discussed:
- A convertible note allows you to raise capital for your business by securing an investment but allocating shares for that investment at a later date
- This is beneficial when your business hasn’t been valued appropriately yet as it hasn’t had a chance to see growth
- Investors also benefit by receiving shares at a discounted price
- There are secured and unsecured convertible notes
- Whether a convertible note is the right option depends entirely in your unique circumstances
- There are a number of other ways to secure funding for your startup
If you would like a consultation on convertible notes, you can reach us at 08081347754 or [email protected] for a free, no-obligations chat.
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