Everything You Wanted to Know about Convertible Notes

One of the most entrepreneur friendly ways to raise early stage financing for your startup is to raise what is called a Convertible Note.

What is a Convertible Note?

A convertible note is one way to raise the cash you need to get your business off the ground. It is a type of short-term debt that converts into equity.  In the context of a seed financing, the debt typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. In other words, investors loan money to your startup as its first round of funding; and then rather than get their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of the note.

Advantages of a Convertible Note

One of the key advantages of issuing convertible notes is that you don’t need to agree on a valuation with your investor(s). That question is kicked down the road until the Series A round of financing – when there are a lot more data points and thus it’s much easier to value the startup (i.e., price the round).  

Accordingly, the issuance of convertible notes disposes of the foregoing three problems. Again, a convertible note is a loan (debt, not equity). A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.

There are advantages of speed, simplicity and cost as well. A startup can close a convertible note round in a day or two by merely issuing a 2-3 page promissory note, which could cost as little as $1,500-$2,000 in legal fees (or a little more if a note purchase agreement is also executed, which is customary). On the other hand, the issuance of shares of preferred stock is complex, and it can take weeks to negotiate all the terms and documents — with legal fees in the neighborhood of $10,000 – $30,000 or more (depending upon whether the investors insist on full-blown Series A-type documentation, as opposed to stripped-down documentation like the “Series Seed,” discussed below).

Full Details

For a lot more detail, make sure you check out this 3 part series posted on Techcrunch by Scott Walker.

Part 1

Part 2

Part 3