Convertible Notes

Convertible Notes are the most popular method for startups raising seed rounds

So what exactly are they?

Normally, when you are an early stage startup i.e. in pre-revenue startup, you can build fancy castles in the air using MS Excel — but not many people would be willing to invest equity in your venture — because

- its riskier for them to invest in equity as compared to debt, because as of now everything is in Excel — if they wait for the Pre-Series/Series A round , they will have greater visibility of where your operations stand

For the entrepreneur also, thru Convertible Notes, you can delay valuation while you focus on product development and market research. The seed round gets you funds for pursuit of growth

Convertible Notes have a clause of automatic conversion, trigger being once the startup has reached qualified financing

Convertible notes also come with a discount feature for the investor — you get a reward in form of a pre-decided discount to the conversion price ; so lets say if the Pre-Series/Series A folks get you equity at 50$ a share, you will get it as 45$ a share ( a discount for 10% as a reward for being an early investor)

Its important for entreprenueurs to figure out the quantumn of discount they agree to in the term-sheet and whether the Convertible notes also carries a coupon rate till the conversion — ideally it should not — because you are already giving a discount on conversion

In addition to the conversion discount, convertible notes also typically have a valuation cap — hard cap on the conversion price for noteholders regardless of the price per share on the next round of equity financing

What do you think are the pros and cons of this method?

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