A convertible note is used by investors to invest in any startup that is not yet ready for valuation. Convertible notes begin life as short-term debt and are then converted into equity by the startup in question.
They are seen as a quick and very straightforward way for a startup to raise money. This type of fundraising is a far less complicated process than having a startup issue equity.
The premise of a convertible note is that investors loan money to a startup in return for an agreed equity stake in the company. This is as opposed to the investor loaning money to a startup and receiving the principal sum plus interest back over an agreed timescale.
Investors see a clear benefit in convertible notes. This is because startups with a high-growth potential clearly offer an outsized investment return.
As for startups, they benefit from convertible notes through the fact that it allows them to focus on growing their business before they need to begin paying back debt. This can be particularly beneficial for tech companies who need to spend extended periods of time fine-tuning their services or products.
In terms of timing for the investor, a convertible note automatically changes into equity once an agreed, specific milestone has been reached. This generally happens once the startup has been officially valued for later investments.
When it comes to modeling out a convertible note, startups will find that using a software-driven cap table tool such as the draft convertible note template that is available in the WOWS Global library Click here is a highly effective method of doing so. This is because it helps founders to understand and manage the impact that a convertible note will have on their cap table.