A convertible note is a short-term debt instrument that startups use to raise capital, with the debt converting into equity at a later date, typically during a subsequent funding round. Rather than repaying the principal and interest in cash, the note converts into shares of the company based on agreed-upon terms, such as a discount rate or valuation cap.
Convertible notes are popular for early-stage startups due to their simplicity, speed, and flexibility compared to traditional equity financing.
How do convertible notes work?
Convertible notes function as a loan provided by investors, but instead of repayment in cash, the loan converts into equity during a future funding round. The conversion terms are pre-negotiated, often including a discount (e.g., 20%) on the future valuation or a valuation cap, which limits the maximum price at which the note converts into equity.
Why are convertible notes beneficial for startups?
Convertible notes allow startups to raise funds quickly without needing a full valuation, which can be challenging at an early stage. They are simpler and less costly to set up compared to traditional equity financing. Additionally, they delay complex valuation discussions until the startup has grown or attracted more investors.
What are the key terms in a convertible note?
- Valuation Cap: The maximum valuation at which the note converts to equity, protecting early investors if the company’s valuation increases significantly. - Discount Rate: A percentage discount on the future valuation during conversion (e.g., 20% off the valuation in the next funding round). - Interest Rate: The annual interest accrued on the note, which may also convert into equity. -Maturity Date: The date by which the note must convert to equity or be repaid if no funding round occurs.
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