What is a convertible note?


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This week on the Funding Simplified series I am moving back to topics around working with investors. One of the funding vehicles that has been gaining in popularity for some time is the idea of a convertible note. Let’s take a look at what a convertible note is, how they work and why they might make sense for your startup. What is a convertible note and how do they work? A convertible note is a type of hybrid funding vehicle that combines aspects of both debt and equity funding. The initial funding phase is considered debt or a loan, typically short-term debt. However, the investor has the ability to convert that debt into equity and usually at a discounted price as compared to future investors. When does this type of funding make sense? Typically used in the very early stages of fundraising, convertible notes work great when establishing a startup’s valuation is difficult. Setting the value of a startup can be tough, for example, if the company is pre-revenue or has yet to accomplish many other types of milestones (users, a prototype, etc.). By using a convertible note the valuation of the business is “kicked down the road” until there is more information that will aid in setting a fair valuation. Another benefit of using this type of funding is that the founder(s) aren’t likely to give up seats on the company’s Board. With standard equity funding, investors often ask for some level of control by becoming a voting member of the Board that directs the company. Under convertible notes, although it is possible, that is usually not the case. When doesn’t a convertible note make sense? The majority of startups don’t need another expense on their books. This type of funding carries interest that is due, at various points in time. Next up This Wednesday on the show I will be talking about an even newer funding vehicle that is a cousin to the convertible note. That is the SAFE, or simple agreement for future equity.

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