Convertible Notes

One traditional way for startups to raise seed financing is to sell convertible notes (also referred to as convertible promissory notes). These seed financings are known as convertible note financings.

Related Article

Although convertible notes have traditionally been popular for seed financings, the trend in Silicon Valley and other major startup ecosystems is toward safes. See Safes.

Notes (also referred to as promissory notes) are promises made by someone to pay a specified amount to the holder of the note (also known as the noteholder) at some time in the future, known as the maturity date. Convertible notes are notes issued by a corporation that convert into shares of the corporation's stock upon certain events. When startups sell convertible notes, the notes typically obligate the company to repay the purchase price plus interest in the event that the note has not converted by its maturity date.1

Although they are notes, both the startup and the investor (i.e. the noteholder) usually intend for the note to convert into stock, rather than for the corporation to repay the note. Typically, convertible notes convert into shares of the series of preferred stock issued in the corporation's next equity financing, as part of that equity financing. Convertible notes often also convert into shares of the corporation's stock if the company is acquired or does an IPO. Most convertible notes have features known as valuation caps or discounts which affect the number of shares the note will convert into. Valuation caps and discounts are explained in our article about safes.

Despite their popularity, many people consider convertible notes awkward to use. Even though investors and startups do not typically think of convertible notes as an obligation of payment, they must agree on an interest rate2 in order to issue a convertible note. If a note has not converted by its maturity date, the investor and company must spend time and energy deciding what to do (usually, they extend the maturity date).

These problems exist because convertible notes were not originally designed for seed financings. They were originally designed for bridge loans - loans made by VCs to companies they invested in, to help those companies survive until their next round of venture capital financing. Startups began using convertible notes for seed financings because the paperwork and negotiation was considerably simpler than for an equity financing.

Recently, various organizations have created alternative forms of investment designed for seed financings from the ground up, in order to address the problems with convertible notes. In Silicon Valley and other major startup ecosystems, these alternatives are gaining popularity over convertible notes.

Often, the terms of the note specify that the corporation does not have to repay the note unless investors specifically request it. In some states, there may be lending regulations that limit how far out the maturity date can be set.
The interest rate cannot be below the applicable federal rates (AFRs) published by the IRS. The applicable federal rate is used by the IRS to determine whether an investment is a loan for tax purposes. Not setting an interest rate or setting an interest rate below the AFR creates tax issues for both the investor and the startup. The accrued interest typically also converts into shares, along with the principal balance (i.e. the amount invested).

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