How to use convertible notes to raise funds for your business
- 1 How to use convertible notes to raise funds for your business
How to use convertible notes to raise funds for your business
get Get capital It can help you grow your business, but if your startup is still in the early stages, raising funds can be tricky. Many institutional investors are reluctant to invest money in companies that have at least no income or growth history. Fortunately, you have a choice. One of the most common ways for early-stage companies to raise capital was to use convertible notes.
What is a convertible note?
Convertible notes are an investment that allows founders to raise funds from investors without first having to conduct a formal company valuation. Unlike a pricing round (equity investment based on valuation), a convertible note is a short-term debt that may be converted into company equity in the future.
Although valuation can give you a better understanding of the company’s value and Grow Potentially, they also force you to price your stock. This is why many founders like the idea of convertible notes. Before setting the price per share, you have more time to understand how your company will grow.
How does a convertible note work?
If investors trust your company, they can provide you with a loan in exchange for notes in the form of convertible bonds. Then, upon qualifying events or transactions (such as the end of Series A financing), the notes will become preferred stocks.
Convertible notes are designed to reward the risk of early investors, which is why they usually come with a valuation cap or conversion discount.
The upper limit of valuation sets the maximum valuation at which investors’ funds can be converted into equity. Even if later investors pay a different price, the upper limit (which determines the company’s per share price) also applies to convertible bond holders.
On the other hand, the conversion discount is a discount to the price per share when the investor’s bill is converted into equity. This means that they can buy preferred stock at a lower price than investors who entered in later rounds.
If the convertible note includes a valuation cap and When converting discounts, noteholders can usually choose to give them the advantage of the lowest per-share price.
Because a convertible note is a form debt, It also comes with terms that help protect investors, including fixed interest rates and maturity (or maturity) dates.The interest on convertible notes is usually 2-8% ratio, Depending on your location.
If the convertible note has not been converted into equity when it expires, you must repay the investor’s principal investment plus interest. Of course, you can choose to extend the expiry date at any time, but you must obtain the investor’s permission to modify the bill.
Secure and convertible notes
Many people see SAFE as an alternative to convertible notes. The similarity between SAFE and bills is that they are both converted to equity, but the process is different.
SAFE represents a simple agreement for future equity. SAFE will convert to stocks in future pricing rounds. Unlike convertible notes, unless the company raises a certain amount of funds, it will not be converted to equity, and regardless of how much funds your company has raised, SAFE will usually convert to equity in the next round of pricing.
Another difference is that SAFE is not a form of debt; they are considered warrants. Therefore, SAFE has no maturity date or interest rate, which may be better for the founders. However, they usually do have valuation caps or conversion discounts that investors can take advantage of.
For founders who want to get funds quickly, convertible notes and SAFE are both good choices. However, convertible notes tend to have more protection for investors, which can make them easier to sell.
Advantages and disadvantages of using convertible note financing
As with any fundraising strategy, using convertible notes to finance a company has pros and cons. Grow.
Advantages of convertible notes
- You can save money and time. The term list of convertible notes is shorter and more straightforward than the round pricing list. When you don’t have to negotiate so many terms, you can save time and reduce attorney fees.
- The notes are simple. If needed, you can change the terms of the comment fairly easily.
- You retain control of ownership. You don’t need major investors to help get more funds.
- You may not need to make an estimate. If you want more time to understand how your company will develop, you can defer the valuation to the next round of financing.
- The bills are attractive to investors. Investors may be more willing to take risks for your company because they are protected by bill valuation caps or conversion discounts.
Disadvantages of convertible notes
- You must be careful to dilute. If you raise too much money using convertible notes, or if the notes are converted at a low valuation or at a large discount, your shares as the founder may be diluted.
- You may have fewer investment opportunities. Without major investors to stimulate interest in your company, it may be difficult to find and ensure the safety of other investors.
- You can still make a final valuation. If you decide to use a valuation cap on convertible notes, you may need to perform some type of pre-investment valuation, which may force you to value the company in advance.
Financing your company
Fundraising for your company can be complicated, so it’s important to gather as much information about your choices as possible. In addition to consulting your accountant and business lawyer for advice, make sure you take the time to review your goals, discuss strategies with your team, and read the fundraising market in your industry.
In the following situations, convertible notes may be an excellent choice for you to raise funds during the seed round:
- You want to raise funds quickly.
- You want to save attorney fees.
- Before making a valuation, you want to have more time to understand how your company will grow.
- You want to retain control of the fundraising process.
- You are ready to pay interest on the bill.
If you like the flexibility of the convertible tool, but don’t want to deal with the accrued interest on your investment, you can also consider using SAFE. However, if you want to better understand the company’s ownership and dilution, you may be more interested in the traditional path of the pricing round.
No matter which route you choose, be sure to weigh your options carefully to find out the direct and immediate benefits to your company. Long-term growthThe Fundbox line of credit may also be a useful source of short-term capital that can be used for growth or peace of mind.
Disclaimer: Fundbox and its affiliates do not provide financial, legal or accounting advice. This content is for reference only and is not intended to provide and should not be used as a basis for financial, legal or accounting advice. You should consult your financial, legal or accounting advisers before making any transactions.