The scale of investors has risen in the golden age of financing, with hopes of landing the next success story such as Google, Facebook, or Amazon. In the following article, startup companies can learn more about the basics of convertible notes and about how their company can make the best out of the convertible bonds.
Without having an established credit history, startup companies aren’t qualified to get a conventional loan. Since a startup is in its initial stage of formation, it is unconvincing for a bank to trust the company. Hence, the startups turn to equity to fund their daily operations. Although, without any value or assets to the company’s name, defining the equity is also impossible. In such a situation, how does a startup get its seed funding? This is where convertible notes come into the picture.
What are Convertible Notes?
A convertible note is an instrument of debt that is used for a short period of time and can be converted into equity – a company’s portion that is under ownership. The initial funding for the startup is provided by angel investing, under which the company can grow further to create its own capital. The purpose of convertible notes is to help increase the pace by which the company earns its income. It is also a less expensive route than giving away the company’s equity while getting the same reliability as that of a conventional loan. In return for the funding received by the startup company, the convertible debt instrument typically converts into equity (stock ownership) in the future round of financing.
Convertible Notes – Are They Hybrid Securities?
What are hybrid securities? Hybrid securities are investment instruments that feature both the characteristics of equities and bonds. Even though convertible notes are originally structured as debt instruments, it also has a great probability of eventually converting into equity. Hybrid securities aren’t as high-risk as equities but more at risk than pure bonds.
Terms Related to Convertible Notes:
Here are some terms and terminologies that are related to convertible notes.
Interest on Convertible Bond
Investors that provide funding to a startup company, will possibly earn interest over their The purpose of having an interest rate on the convertible debt instrument is to assure that the investors can get a minimum rate of interest as their returns. If in case, the startup is unable to raise enough capital and the bonds don’t typically convert into equity, then the interest on the convertible bond will assure that the investors do get the minimum rate of interest with their funding amount. This will result in the investors making a low percentage of interest at maturity.
When it comes to building interest on the convertible debt instrument, the amount isn’t a series of transactions made in cash but rather an amount that is accumulated over a period of time.
Maturity Date
The convertible notes that are provided by the issuer come with a maturity date – which signifies when the convertible debt instrument bond is due or payable to the investor. If in case the notes have not already converted into equity by the maturity date, then the company will have to repay the investor along with the minimum interest amount. The future round of funding is also set by the maturity date of the convertible note.
Valuation Cap
The valuation cap is an added bonus for those investing in the startup at an early stage. A valuation cap can be defined as the value of the company that can help set a limit to the amount that the issuer will pay in case the debt converts into equity. The valuation cap is an ‘agreed upon’ amount or the maximum valuation that will set the price per share in the future round of funding. The price per share is decided by the division of the valuation cap. It makes it clear for the investor that the convertible note won’t be valued more than the agreed value cap. This allows the investors that have been issued convertible notes to cap the lower valuation price when converting the bonds into equity. Convertible bonds have a valuation cap which helps to adjust a limit price per share by division of value cap with a number of shares. In case if the company’s value is lesser than the cap value, a valuation cap isn’t used in such a situation.
How Can Startups Benefit from Convertible Notes?
Startups can benefit from convertible notes in numerous ways. Angel investors, friends and family, venture capitalists are all sources that can help raise funding for a startup in its initial stage. Investors may also choose to invest using convertible notes which makes it easier for the startups to document. Based on legal processes, convertible notes prove to be more inexpensive than other investments and result in quicker financial rounds. Unlike equity bonds that require various documents for the closure of the financial round, convertible debt instruments take less time and expense to complete a round of funding.
Other than this, the valuation cap (company’s value at the time of investment) determines the rate of shares that are offered. The decision regarding the cap value is difficult for a startup to make as it is in its early stages. Convertible notes make this task easy for issuers as they need not guarantee a fixed valuation of the company until the next round of financing. This provides enough time for the startup ventures to develop appropriate standards that can help to decide a fair rate for the next round of funding.
Now that you’ve gained enough knowledge about convertible notes and startups, here’s your chance to develop your own idea into a successful business. If you’re looking to sharpen your strategy skills to build a great venture, this guide will surely help you out – 7 Business Strategies to Build a Successful Startup.
