Raising Money using a Convertible Note

By Spartina.com & CoolBizApps.com     2 comments     Add your comments

In-depth look at the questions to consider when looking at a convertible note to raise money for your internet business.

Disclaimer: This article is for discussion and educational purposes only and should not be construed as legal advice. Legal advice can only be given by legal professionals. Please seek the advice of a lawyer before proceeding on Convertible Notes.

What is a Convertible Note?
For an early stage company seeking to raise money, there are two main routes. One is to issue equity (a share in the company) to an investor in exchange for a cash investment. However, in order to defer putting a valuation on the company’s stock, another way is to borrow the money, with the intention that the loan eventually converts into equity. This is the essence of what is called a “Convertible Note.” 

A Convertible Note is debt that the company incurs, that can be converted into stock based on certain conditions.  A Convertible Note is commonly used for a small first angel round ($100k-$500k) to provide financing on terms that will be decided at a later date when additional, often professional investors participate.  Thus it's often called a Bridge Financing.

A Convertible Note is also known as a debt offering since the company literally goes into debt to the investors until the price of the Note is paid back, plus interest, or until it is converted into stock.

Why do it (the Company)?
You want to raise capital to grow your business and you need to be efficient from a time perspective and keep legal costs to a minimum. There is a great deal of work, which costs time and money, to create a stock offering. If you are only looking for a relatively small amount of funding, for example, under $500k, then a Convertible Note is much simpler. For example, the legal fees for a Convertible Note might be in the range of $2,000-$5,000, while the fees for a Series A could be $5k-$50k, as you might also pay for the fees of the investors.

In addition to being quick and relatively straightforward to execute, these funds will allow you to make progress and improve your valuation for your subsequent financing.

Another benefit for the company borrowing the money is that you might get the cost of the Convertible Note at a lower interest rate, since the lender/investor has the option of converting it into stock.

The company must record the Convertible Note as a debt in its balance sheet. If bankruptcy occurs, the Note holders are considered creditors and must be paid back by the company’s remaining assets.

Why do it (the Investor)?
The investor wants to invest in the Company today and believes a subsequent financing is around the corner. The investor is seeking to benefit from the same terms (e.g. Liquidation Preference) as the next investors, who also might be better equipped to price the round. The investor seeks to be compensated for the risk of investing early through terms in the Note.

Investors sometimes object to convertible debt financing because they don’t know how long it will take for the next financing to occur, and the company’s value could increase much more than the discount their Note provides them. This leaves them having taken a much larger risk than the next-stage investors, and enabled the company to significantly increase its value, yet they pay a price close to that of the next-stage investors. One way to mitigate this concern is to cap the valuation that will be used to calculate the share price for the Note conversion.

In general, if there are sufficient protections in the terms of the note, (see below), then angel investors will be willing to work with this method of investment. It is a way of getting cash to a company quickly so it can grow sufficiently to make it to the next round of equity investment. Once that first round is done, the investors’ loans convert, and then they are holding equity.

In the articles below, common terms are explained, including the incentives to the investor, as well as the protections they will need. A quick review will help you optimize your time with company counsel.

Variables and Levers:
Interest Rate, Duration & Maturity Date
Conversion, Automatic Conversion, Conversion Discounts
Warrants
Cap
Note Round: Size, Closing Date
Early Sale; Other Terms

References:http://www.startupcompanylawyer.com/category/convertible-note-bridge-financing/

Legal Help: We have worked with the following lawyers on Convertible Notes, and recommend their services:
Buddy Arnheim (barnheim [at] perkinscoie.com), Perkins Coie
John Cook (jcook [at] orrick.com), Orrick
DJ Drennan (drennan [at] smlaw.com), SMT
Simon Inman (srinman [at] cmprlaw.com), CMPR
David Marks (dmarks [at] mhfmlaw.com), Marks Holmes Foley and Morales

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Reader Comments

2 comments

Convertable notes

From: John Edwards, 11/09/10

All these convertible note articles are excellent and REALLY helpful. Thanks

Great Posting -- Here's how I did it.

From: Rob, 11/15/09

I enjoyed your posting -- here's my personal experience raising over $1 Million through convertible notes/bridge loans: http://www.purchase.com/blog/fundraising/how-to-raise-money-using-a-bridge-loan-or-convertible-note