As with any business, early-stage companies have the option to either raise funds through equity or debt. While both the mechanisms have their own set of pros and cons, convertible notes offer a hybrid solution to match the needs of early-stage investing.
In a way, they work as short-term loans to the company for which the investors receive interest payments. However, they also get converted into equity when a predetermined condition is met. The predetermined conversion event is generally a future round of funding or exit event.
Points to be Considered When Investing in Convertible Notes
It goes without saying that investors must exercise caution and perform their own due diligence before deciding to invest in convertible notes. The primary aspects that need to be looked into are:
Valuation Cap: It is important for investors to be careful of the valuation cap mentioned in convertible notes documents. It will help protect them against dilution of stake due to future rounds of financing.
Discount: Being granted a discount is another important factor. It determines the discount rate that the early-stage investors will receive for investing in future rounds of financing, as a reward for investing early on in a risky venture.
Interest Rate: Since convertible notes are a type of loan, investors must look at the interest rate being offered. In the case of crowdfunding, interest is usually not paid back in cash, but it gets accrued and converts into equity.
Maturity Date: It is the date on which the note is due and needs to be repaid by the company.
Pros of Convertible Notes
Convertible notes are the most common methods of investing in early-stage companies. They are simple and uncomplicated, and they offer the “best of both worlds.”
Investors investing in convertible notes receive an interest payment, along with becoming an equity stockholder in the company upon conversion. Rights of the convertible note holders are protected by the means of valuation cap, discount rate, and interest.
Convertible notes are ideal instruments for investors who are willing to take the risk of investing in a startup without getting involved in the complications of valuations. At this time, the company has not yet developed the metrics to value the company, yet there are high rewards associated with these high risks.
Cons of Convertible Notes
Some of the pros can also be treated as cons by some investors. For instance, uncertainty associated with valuation can be considered a drawback. Since the company is not yet valued, investors do not know whether the terms of the notes offering are fair. Therefore, some investors wait for a priced round to determine the value of the company before investing in convertible notes.
In addition, convertible note holders do not have voting rights, ownership rights, or pro-rata rights as they do not yet own equity.
Whether or not to invest in convertible notes depends on individual investors’ risk-appetite and personal preferences. If they are willing to forego rights associated with equity ownership and are ready to face risks associated with debt financing, convertible notes turn out to be profitable forms of investment in numerous cases. There is a reason that convertible notes has emerged as a preferred method of investing in the crowdfunding market.