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.
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.
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:
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:
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.
How does this save time? one word – negotiations.
When carrying out an equity capital raise, the Company needs to work out:
With a convertible note, all that is really needed is:
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.
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.
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
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.
If the valuation of the startup exceeds the conversion cap, the conversion rate is adjusted so that the investor gets more equity.
Yes, convertible note agreements are legally binding documents that outline the terms and conditions of a loan.
Convertible notes are typically used in seed funding rounds, but they can be used for later stage funding rounds as well.
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.
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.
Cake allows you to create legal contracts, send them for signing, and automate your contract management, all in one place.
