What is a convertible note?

We explain what a convertible note is, a startup financing instrument that is very well known in the US and which in Spain is appearing more and more frequently as a common term in the financial vocabulary.

What is a convertible note?

The convertible note is a startup financing instrument that is usually recommended for entrepreneurs who need the money as soon as possible in order to implement their business plan and create more value before closing an A round. It is a short-term loan which automatically becomes preference shares once a Series A round of funding has been closed, i.e. the investor lends the money to the start-up as in a first round of investment and receives, instead of equity and interest, preferred shares in the start-up, based on the terms and conditions of the note.

It all depends on the degree of maturity of the project, the previous contacts the start-up may have had with venture capital firms, the window of opportunity it has to validate its hypotheses, its cash flow needs, etc.

Discount and cap on convertible note

In a convertible note, the investor assumes a higher risk than a direct investor in the next round, having invested at an early stage of the start-up. For this reason, the convertible note investor is typically charged a discount in order to compensate them for the higher risk taken. This discount must be negotiated, and it is common to establish different discounts depending, for example, on the time elapsed until the next round of investment takes place (the longer the time elapsed, the higher the discount).

The cap of the convertible note is to determine a maximum valuation of the start-up for the purposes of converting its note into equity. In this way, the investor will convert at the lower of the value set in the next financing round and the agreed cap. In this way, the maximum valuation is guaranteed at that time, even if the figure is higher in the next round.

Discounting and cap are not mutually exclusive, but rather can coexist. If the convertible note has a discount and a cap, the investor will convert it at the lower of the valuation obtained after the discount and the valuation agreed in the cap. In both cases, the correct setting of the values is crucial (discount not too high or cap not too low) so that the second investor does not feel uncomfortable with the operation and the dilution of the initial team is not excessive.

Advantages and disadvantages of the convertible note

Like advantages of the convertible note with respect to other investment formulas, we can mention that:

• It facilitates the negotiation process and the necessary documents.
• It reduces investor uncertainty, as the valuation of the next round will usually be carried out with more objective elements.
• It allows to add inverters one by one.
• It reduces the need for lawyers and external advisors.
• It leaves the bulk of the start-up due diligence process to a post-investment stage (depending on the amount of the note), which will typically coincide with the next round of investment.

In terms of their disadvantagesSometimes, the interests of first and second investors can be aligned against the entrepreneurs. If the first investor enters with equity, he will be interested in getting the next round at the highest possible valuation of the startup (thus reducing dilution); however, if he enters on a convertible note, he will be interested in getting the second round at the lowest possible valuation, as this will allow him to get more equity. However, this does not always have to be the case, although it is best to bear this in mind.

If you would like to know more about other topics around M&A, please see our section on HowTo.