A convertible note is basically a type of security which includes various instruments that are expected to be converted into stocks in future. These are your debt equity. These notes or series of agreements are issued to the investors at a very early stage in exchange for a share or stock later.
It is also essential to know why these convertible notes are issued. Let us say that a friend of yours asked you for investment in their start-up but he didn’t have anything more than a fantastic idea to go ahead with. So it is but obvious that your investment or share in that to-be-company at the current moment holds no value. This is where your notes come into picture. It allows you to invest in your friend’s start-up by lending him your money, and this debt that you give him right now, later gets converted into a stock with value. You can also lay down special terms to these notes which will make your investment worthwhile. This benefits the entrepreneurs as they can get investors without having any upfront stock value.
Convertible notes have some very unique features: Maturity, Valuation caps and Discount Conversions, and Dilution.
- It is to be noted that maturity of these depends upon the preferred rounds conducted by the firm. The maturity date is a deadline for the preferred round, suppose the note has a 2 years maturity and the company has not conducted a preferred round in this time, the investors can have their money back.
- The investors have a choice of going for valuation cap or discount conversion. Although both terms will be applicable, only one will be carried out during conversions. The investors can choose the term which is giving them more benefit
- No matter what term, there is always going to be a dilution during conversion, but only the terms will decide how extreme the dilution will be
Even if these sound very affordable and attractive for entrepreneurs, the real catch is in the terms, so a word of caution- pay close attention to the terms while accepting these. If utilized correctly, they are a win-win for both the investors and founders, but if not then the founders may have to face heavy costs.
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