Finding investors for your early-stage startup can feel particularly challenging. When you’re working with what might amount to little more than a good idea and a basic product, it’s hard to quantify. And yet, so much of startup financing hinges on getting a valuation for the company.
Fortunately, that’s not your only path forward. With convertible notes, you can get investors on board well before your company gets officially valued.
The basics of convertible notes
A convertible note is a legal document that says that in exchange for an investor giving your startup a set sum of money, you promise to convert that money into equity if/when a triggering event occurs at your company. It’s essentially a type of short-term debt that you pay back in the form of preferred shares when your company has a valuation that you can work off.
Because it doesn’t require a company valuation now, many early-stage founders use convertible notes to fundraise. It gives you a way to get money today in exchange for the promise of shares down the road.
What would cause you to owe that investor company shares? It depends on the fine print of your convertible note, but generally, the triggering event could include:
- A future fundraising round
- An IPO
- A merger
- An acquisition
Most convertible notes stipulate that fundraising rounds will only trigger a conversion event if they raise a set minimum amount. This protects you from owing equity if a round of fundraising doesn’t quite go according to plan.
Because convertible notes are basically a type of debt, most startups record them on their books as such up until the triggering event. After that point, the amount converts into equity.
You should also know that like other forms of debt, the money loaned to you from the investor accrues interest per the terms of your convertible note. You won’t need to pay that interest back in the form of liquid capital, though, which is good news since these rates have gone up recently. Instead, what accrues converts into more equity for the investor at the triggering event.
Convertible note fine print
To help you get a firm grasp on how all of this works, let’s talk about some of the details most convertible notes include.
Upside for investors
To reward investors for jumping in with your business in its early (read: high-risk) days, convertible notes usually come with at least one of these perks:
- A discount rate — This entitles the investor to a discount on their share price. At the triggering event, the discount applies to help their invested money plus accrued interest cover more shares. Discount rates of around 20% are common.
- A valuation cap — This sets a maximum at which the investor’s shares will be converted. While you want a valuation as high as possible, the investor actually prefers a lower valuation cap. Let’s say your company gets valued at $10M in its Series A. If an investor has a convertible note with a valuation cap of $7.5M, their preferred shares get priced based on the $7.5M cap, not the actual $10M valuation. And that means their investment converts into more equity.
Some convertible notes include both a discount rate and a valuation cap with terms that say that the investor can use whichever gives them the best share price at the triggering event.
Requirements for startups
In exchange for loaning your money, investors want something back — and they want to know when they’ll get it. That’s why convertible notes include:
- An interest rate — This is no different from interest on any other debt. The interest accrues as long as the convertible note is in place. Rather than getting paid back in cash, though, the accrued interest adds to the investor’s total that gets converted into equity at the triggering event.
Founders should know that interest rates for convertible notes have gone up in 2023.
- A maturity date — Speaking of that triggering event, what if it never comes? To ensure you can’t run off with an investor’s money forever, convertible notes include a maturity date at which point you will theoretically need to pay back the investment if you haven’t yet reached a triggering event.
Maturity dates should be taken seriously, but you should also know that very few founders find themselves coughing up lump sums if they reach that date without a conversion event. Most startups wouldn’t be able to pay back the conversion note, and investors know they would likely be forcing a bankruptcy — and consequently forfeiting that money — if they tried to require repayment.
Instead, if the maturity date draws near, most investors will negotiate the convertible note — offering a maturity date extension in exchange for a more preferable valuation cap, discount rate, or both — or convert the note into equity at the maturity date. The latter is rarer.
What happens if there’s a liquidation event
What if your company gets acquired rather than going through an official fundraising round or going public? The terms of your convertible note should make this clear.
In one case, the note’s terms may say that the investor gets paid back per their liquidation preference, which is usually up to three times the original amount they loaned. In others, they can convert the note into common stock priced per the valuation cap, then sell those shares to the acquiring company.
The general accounting treatment of a convertible note involves initially recording it as a liability on the balance sheet. Over time, interest will accrue, and any potential conversion into equity should be accounted for when the conversion event occurs.
Here’s a step-by-step overview of the accounting treatment of a convertible note:
1. Initial issuance: When the company receives funds from an investor through a convertible note, the company records the liability.
|Convertible Notes (Liability)||100,000|
2. Interest accrual: Over time, interest will accrue on the convertible note. This accrued interest will be recorded as a liability, usually under “Interest Payable” or “Accrued Interest.” – Let’s say for example purposes there was $5,000 in accrued interest.
3. Conversion into equity: When the convertible note is converted into equity, the company will remove the liability and record the equity issuance.
Journal entry (assuming a $105,000 conversion, including the initial principal and accrued interest):
|Convertible Notes Payable||100,000|
|Preferred Stock + Additional Paid-in-Capital||105,000|
These journal entries are a simplified example of the accounting treatment of a convertible note. The specific terms of the note, including any conversion discounts or valuation caps, may affect the journal entries. It is essential to consult with a professional accountant or financial advisor to ensure proper accounting treatment for your specific situation.
Convertible notes vs. SAFEs
Convertible notes were the go-to for early-stage founders for a while, but simple agreements for future equity (SAFEs) have recently become an increasingly popular option.
Unlike convertible notes, SAFEs don’t include an interest rate or a maturity date. They offer a similar founder upside without some of the fine print that can come back to bite you. Because they don’t come with some of the negotiables — like the aforementioned interest rate or maturity date — SAFEs are generally faster to execute than convertible notes, too.
That said, because they have fewer investor-preferred safeguards, they can be a harder sell. Many investors (understandably) prefer convertible notes to SAFEs. In your seed stages, you may need to be flexible and go with what potential investors want.
Either way, though, think carefully through the ramifications, like your own dilution and tax reporting. For help understanding what convertible notes and/or SAFEs would mean for your startup, get in touch.