Convertible note agreement template

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What is a convertible note agreement

A convertible note, also known as a convertible promissory note, is a short-term debt instrument that allows investors to lend money to a company with the expectation of converting the loan into equity in a future financing round. Put simply, it's a way to raise through a mixture of debt (a loan) and equity (giving away shares).

A convertible note agreement is a legal document that outlines the terms and conditions of a loan that can be converted into equity in the future. Essentially, it's a way for startups to raise money without having to give away equity upfront. Convertible notes are often used in seed funding rounds because they allow startups to raise money quickly and with minimal negotiation.

How does a convertible note agreement work

When an investor agrees to invest in a startup using a convertible note agreement, they are essentially loaning money to the startup. The loan comes with an interest rate and a maturity date, which is the date by which the startup must repay the loan. However, instead of repaying the loan with cash, the startup has the option to convert the loan into equity in the future. The conversion rate is typically determined by the terms of the note and is often based on the valuation of the startup at the time of the conversion.

Benefits of using convertible notes

The big advantage with this form of raising is that you don’t really need to know what your company is worth to get the funds in your account – you simply agree that when your company does eventually do a raise and your equity is valued, the lender (investor) will be provided shares at that value based on the funds provided (with any discount that might be agreed).

This keeps everyone happy! The investor can be rewarded for taking the risk in investing early, by getting the opportunity for discounted shares, or at worst, getting their money back with interest; and the company gets money in the bank, can extend its runway, and be in a stronger position to raise more funds once everything is more certain. Let's break that down:

For investors

  1. Flexible terms. Convertible notes offer flexible terms for both the investor and the startup founder. The terms of the note can be negotiated to meet the needs of both parties.
  2. Lower valuation risk. By using a convertible note, investors can avoid the risk of valuing the startup too early. The valuation of the company can be determined at a later date when more information is available.
  3. Delayed dilution. By using a convertible note, investors can delay the dilution of their equity until a later date when the company has a higher valuation.

For startup Founders

  1. Access to funds, fast. Convertible notes are often easier to obtain than equity financing. This is because the terms of the note are generally less complicated than those of an equity financing round.
  2. Lower legal fees. Because convertible notes are less complicated than equity financing rounds, the legal fees associated with them are typically lower.
  3. Delayed valuation. By using a convertible note, startup founders can delay the valuation of their company until a later date when the company has a higher valuation.

Convertible note agreement template

Cake provides a built-in and lawyer-approved convertible note agreement template that you can use and customize to your requirements.

This template covers the following components:

  • Company details
  • Investor details
  • Investment amount
  • Interest rate
  • Maturity date
  • Valuation cap
  • Discount rate
  • Conversion terms
  • Digital signing
  • Repayment provisions

With Cake, you can keep track of your convertible notes in the Notes Registry, allowing you to easily see the fully diluted share table (in graphs and more), and also to be notified of upcoming events (such as maturity dates). Investors can also keep track of their convertible note investment here too, giving them transparency and confidence in their investments.

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How will convertible notes save you time

How does this save time? one word – negotiations.

When carrying out an equity capital raise, the Company needs to work out:

  • how much it is worth
  • how much the investors should pay
  • what class of shares should be provided
  • whether the Shareholders Agreement needs to be amended to suit those investors. (Take note: often, this will take the most time. As investors will be getting their shares up front, they may want to know the exact terms on which they are issued)
  • and ultimately, how many shares the investors get

With a convertible note, all that is really needed is:

  • prepare the Convertible Note Agreement, i.e. discount, interest rate, and maturity date. These documents can be relatively simple and allow transparency to all parties
  • get Shareholder Approval (if required), and
  • collect the money

While you can do equity raises quickly and easily, if you do get stuck, the convertible note may suit you for now.

Many companies also use a Convertible Note as a bridge, to get extra funds in between equity rounds.

Keep the future in mind

One thing to keep in mind when using convertible notes, is your future plans. Don’t forget that it is likely these note holders will, at some point, become shareholders.

  • How many shareholders do you want in total? Don’t forget the 50 shareholder limit rule for private companies!
  • Also be weary of giving too much of your company away in early rounds. For example, don’t issue too many convertible notes before going through a low valuation round, or you may end up giving away more ownership than you hoped.

Capital raise through convertible notes

We have had first hand experience of the benefits of raising through Convertible Notes here at Cake – so we can really vouch for the springboard they provide.

A Convertible Note worked well for Cake as we were able to obtain early funding which allowed us to build and grow, while avoiding the delays and complications of a valuation. It still offered a financial return to investors via the 30% discount to the priced round. With the Convertible Note funding we progressed the company to achieve milestones that allowed a priced equity Seed Round.
- Jason Atkins, Cake CEO

FAQs on convertible notes

1. What happens if the startup doesn't convert the note into equity?

If the startup doesn't convert the note into equity by the maturity date, the investor can choose to either extend the maturity date or demand repayment of the loan.

2. What happens if the valuation of the startup exceeds the conversion cap?

If the valuation of the startup exceeds the conversion cap, the conversion rate is adjusted so that the investor gets more equity.

3. Are convertible note agreements legally binding?

Yes, convertible note agreements are legally binding documents that outline the terms and conditions of a loan.

4. Can convertible notes be used for later stage funding rounds?

Convertible notes are typically used in seed funding rounds, but they can be used for later stage funding rounds as well.

5. How does a convertible note differ from a safe?

A convertible note is a loan that can be converted into equity in the future, while a safe is a simple agreement for future equity that doesn't involve a loan.

6. Are convertible notes a good way to raise money for a startup?

Convertible notes can be a good way to raise money for a startup, especially in the early stages when the value of the startup is uncertain. However, like any funding mechanism, they have their pros and cons and may not be the best option for every startup.

If a convertible note is something you might be interested in to raise capital or extend your runway, get in touch with the team or sign up to get started.

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