In the dynamic start-up ecosystem, finding financing methods that fit the specific needs of the project is crucial. One of the financial instruments that has gained popularity in recent years is the convertible note. But what exactly is this mechanism and how can it benefit your startup?
What is a convertible note?
A convertible note is a type of short-term loan that allows investors to convert the borrowed money into shares in the company at a later stage, usually during a future funding round. Unlike a traditional loan, which is repaid with interest, this type of agreement offers investors the possibility to participate in the startup’s growth by transforming their loan into equity.
How do convertible notes work?
To understand how it works, it is key to distinguish between a conventional lender and an investor using a convertible note. While the former only expects to receive interest on the borrowed capital, the latter acquires an additional right: the option to convert his loan into equity in the company. This can result in a significant gain if the start-up prospers and its value increases over time.
At the operational level, convertible notes include clauses stipulating how and when the conversion of the loan into equity will take place. It is essential that these clauses define a clear timeframe and the specific terms that will determine how many shares correspond to the amount borrowed and the interest earned.
Key elements in a convertible note
For a convertible note to work effectively, it is important that the contract contains certain essential elements:
- Amount of the loan: It is essential that the exact amount of money that the investor is providing is specified.
- Interest: As with any loan, interest will accrue and should be clearly specified in the agreement.
- Discount or conversion rate: In many cases, investors are offered a discount on the future valuation of the company, allowing them to get more shares for their investment. This incentive is a way to compensate for the risk taken by investing at an early stage.
- Valuation of the startup: Although an initial valuation is not always established, it can be useful to agree on a mechanism for determining it in the future. This will directly influence the amount of equity the investor will receive.
- Conversion period: As an instrument designed for the early stages of a project, it is common to set a period of one to two years for the conversion of the loan into shares.
- CAP clauses: These clauses set a maximum limit on the valuation of the company for conversion purposes. It is a protective measure for investors, preventing an excessively high valuation from reducing the amount of shares to which they are entitled.
Benefits of convertible notes
Convertible notes are attractive to both startups and investors for a number of reasons:
- Agility in raising funds: This type of agreement allows the start-up to quickly access capital without the need for complex valuations or additional paperwork.
- Incentives for investors: Discounts and CAP clauses act as incentives, rewarding investors for the risk they take in financing a start-up project.
- Simplicity: The simple nature of convertible notes reduces the costs associated with the formalisation of the contract, such as notarisation or registration with the Commercial Registry.
While convertible notes are a powerful tool for startup financing, it is vital that both entrepreneurs and investors understand the risks and ensure that the contract is well structured to protect their interests.
This publication does not constitute legal advice.
_____
How can we help you from LAW4DIGITAL?
At LAW4DIGITAL we are lawyers specialized in digital businesses. We provide comprehensive legal advice to digital companies. We help you with online legal advice.
We will keep you updated on digital business. In any case, you can contact us by mail addressed to hola@law4digital.comby calling (+34) 931 444 820 or by filling out our form at law4digital.com.
We are waiting for you in the next post!
Law4Digital team.