What is convertible note investment?

investment instrument

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What is Convertible Note?

A Convertible Note is a technique that seed investors use to invest in early-stage businesses whose valuation is not yet determined. It is a short-term debt structured to a start-up investment that isn’t ready to get evaluated yet. Once the company is valued, Convertible Note is changed into equity.

The amount of the note and its accrued interest will convert into shares of the specified stock at the close of round A financings.

For this reason, a convertible note will be easier to issue and comes with low legal fees for the company at that time.

For example, an investment company buys $25,000 of convertible notes which carry an 8% interest rate and a 20% conversion discount. Within a period of 18 months after selling the convertible notes, the firm trades equity at $3.50 per share. Up to this point, the total interest for the notes will be $3000, and the total amount due to the notes will be $28,000. With a discount of 20%, each share will attract a conversion price of $2.80 and the investor will garner 10,000 shares of the fresh stock. If the investor was to buy the ordinary shares during standard financing, they would only receive 7,143 shares. So, there is a big perk for investing in a convertible note.

Advantages of a Convertible Note Investment

A convertible note has many advantages. Here are some reasons why many start-up companies use them for fundraising.

The simplicity of documentation: Convertible note investments are more simplified to document in terms of a legal view. They are not expensive, and closing the rounds is easier. In essence, both the company and the investors postpone the trickier details until the equity closing, where many corporate documents will then have to be updated.
The company can delay valuation of itself: Convertible notes will allow the company to postpone placing a value on itself. This aspect is very good for companies in the seed stage who have had no time to gain traction in product or revenue. The convertible note will allow them to push this decision later.
Easy way to raise large amounts of money: Companies that want to raise large amounts of funding between funding rounds will use convertible notes. The notes make navigating the strategies easier and easily raising large amounts of money while still delaying the valuation decision.

Drawbacks of Convertible Notes

Although Convertible notes come with multiple perks, they have various downsides. Here are the main ones:

Failure of repayment: Convertible Notes instruments work well with early-stage businesses. A prominent danger with startups is that the risk of failing to repay the loans is high. If the company cannot secure the subsequent equity funding, it might lack enough capital to service its loans.
Heavy debt: Startups have a big challenge to secure financing during a financial crisis. At such times, investors will be interested in those companies capable of uptake secured loans. Since Convertible Notes offer no security, investors may shun them.

Details of Convertible Notes

A convertible note’s original structure is of a debt investment. However, the instrument allows the principal and accrued interest to convert to an equity settlement in the future.

Basically, convertible note investments are like debt instruments. The notes have terms on the interest rate and maturity. They will automatically convert into Equity if and when an equity round is raised. The conversion will always happen at a discount per share in a future round.

When assessing a Convertible Note, it’s important to evaluate the following parameters:

Discount Rate: This represents the valuation discount you enjoy for bearing the risk at the early stages of a company.
Valuation Cap: This is an extra bonus for bearing the risk at the beginning.
Interest Rate: Just like the interest a loan attracts, Convertible Notes also attract interest for your principal amount.
Maturity Date: The due date of the Convertible Note.

Convertible Note Investment in Rundit

Rundit is an investment management software to support various transactions like convertible note investments.

Investors can convert convertible notes into equity, pay-back or written-off debts with transparent details attached to each transaction. The platform will automatically calculate your fund holdings and investment returns accordingly. That said, you will put your mind at ease, and wait to reap the benefits of your investment.

Conclusion

If you have to use a convertible note, make sure you clearly understand both sides of the coin. Be sure to consider what could happen in different scenarios: If things go very well, your investment and accrued interest will translate to equity shares. On the other hand, however, your convertible note investment could go very badly, and you can’t raise enough equity.

An investment management tool like Rundit will help you manage your fund investment and track your portfolio to avoid bad surprises. Give Rundit a try today.