Raising Funds with Convertible Notes

‍In 2004, when Facebook had its only users as university students, venture capitalist Peter Thiel invested $500,000 in the social network company. The investment was in the form of a convertible note, which later converted to a 10.2% equity stake in Facebook in 2005.

This is one of the many examples of early-stage startups obtaining funding before they had any proven track record.

Early-stage startups have insufficient information to determine an accurate valuation. They do not have a fully developed product, revenue, or assets upon which valuation can be done.  

Hence, it's difficult for them to obtain equity financing from angel investors or venture capitalists. As a result, startups often turn to convertible instruments, delaying the task of performing the valuation until a later date when it's easier to do so.

What is a Convertible Note?

Convertible notes are issued as a debt and can be converted into equity in a future conversion event, such as the next funding round. Since they act as a debt before their conversion, they have an interest and maturity date attached to them.

A seed round that involves convertible notes is also called an unpriced round. For investors who are now holders of convertible notes, the next event they anticipate is the subsequent financing round that is priced.  

A priced round also implies a conversion event that allows noteholders to convert their investments into equity.

Since the investor takes a high risk by investing at an early stage, they are given additional benefits on top of interest for the loan. These benefits are given in the form of a valuation cap and discount during the conversion event.

In India, companies need to fulfil certain conditions to issue convertible notes. Convertible notes must be issued for amounts greater than or equal to Rs 25 lakhs. This amount should be either converted to equity shares or repaid within 5 years from the date of issuance.  

Further, the terms of issuance should be determined upfront at the time of issuing the notes. And only those startups can issue convertible notes, which are registered under the Department for Promotion of Industry and Internal Trade (DPIIT).

Standard Terms to Negotiate in a Convertible Note

While principal loan amount, interest rate, and maturity date are the most basic things to decide while issuing convertible notes, there are other factors that need to be negotiated by founders and investors in advance as well.

• Scenarios: What happens to the convertible note in various liquidation events, such as the startup getting acquired or the maturity period is reached before the conversion event.  

There can be different payouts in such cases:

1. Loan repayment with interest: This is the most founder-friendly provision where the investors are paid the loan amount with interest. Naturally, most investors would not agree to this provision as the benefits (interest amount) are very low compared to the risk they take by investing in early-stage startups.  

2. Conversion takes place: This provision is the most investor friendly as it allows the investors to take payouts as if the conversion has taken place. Under this provision, the noteholders share in any upside if the startup is acquired.

For example, suppose the noteholder invested Rs 50 lakhs with a valuation cap of Rs 2.5 crores, then for sale at Rs 10 crores valuation. In that case, the investor will get 2 crores (20%) from the sales proceeds in addition to the interest on the loan.

3. Premium (Intermediate Approach): This is a balance between the above-mentioned approaches. Under this provision, the investor gets a multiple of the loan amount in addition to the interest.

These multiples can range from 1.25x to 2.5x. So, continuing with the above example, the investor will receive 1 crore for 2x premium along with the accrued interest.

With Qapita, you can model various cases to see how much you will get in different scenarios.

Pro Tip: Conduct a scenario analysis to weigh the pros and cons of convertible notes to ensure the terms are fair and the interest obligations are easily manageable.

• Qualified rounds for conversion: Automatic conversion of notes when the financing round is met in terms of minimum amount and valuation.  
• Discount Rate: To allow noteholders to purchase shares at a lower price than investors that join later. The discount enables early investors to get equity at a lower rate than that paid by Series A investors.
• Valuation cap: To allow noteholders to purchase shares at a predetermined valuation ceiling. The investor benefits from the valuation cap as it sets the maximum price that the convertible notes will convert into equity. The lower the cap, the more beneficial it is for the investor.

Let's say the founder and investor agree on a valuation cap of Rs 5 crore. If the subsequent funding is raised at a valuation of Rs 10 crore, the noteholder will get the shares as if the valuation is Rs 5 crore. But if the valuation is less than Rs 5 crore, say, Rs 3 crore, the conversion will take place at a valuation of Rs 3 crore.

Note that there doesn't need to be both the provisions, the discount and valuation cap, while issuing the convertible notes.

Example

• Loan Principal Amount: Rs 60 lakhs
• Interest Rate: 20% per annum simple interest
• Maturity Date: 31st December 2022
• Qualified Financing: Raised a minimum of Rs 5 crores
• Discount Rate: 20%
• Valuation Cap: Rs 9 crores
• Conversion Price: Both the discount and valuation cap is applicable

Now, let's say the priced round is valued at Rs 10 crores. Hence, the conversion will take place as it is a qualifying round. But since it is greater than the valuation cap, the conversion will take place at Rs 9 crore.

Suppose the shares are priced at Rs 90 after 12 months of issuance when the conversion occurs.

The Rs 60 lakhs investment is now Rs 72 lakhs with accrued interest.  

Share price for noteholders with 20% discount = 72 Rs per shares

No. of shares the investors will get = 72,00,000/72 = 100,000 shares

Advantages of Convertible Notes

1. More attractive to investors: Investing in startups is risky but convertible notes protect investors’ principal on the downside and allow them to participate in the upside should your company succeed, making it a more attractive investment.

2. Simpler and quicker to close: Startups can obtain funding much quicker than a priced equity round, which is more complex, time-consuming and requires high legal fees. Convertible notes are beneficial for early-stage startups, for whom time is of the essence.
   

Risks of Convertible Notes

1. Unexpected dilution and potential change of control: Since no shares are being issued, founders may agree to terms that turn out to be unfavourable only in the future financing round.  

For example, noteholders may receive too many shares at conversion, causing founders to dilute and even lose majority voting power early in the startup.

2. If there is no conversion to equity, it can lead to the startup going bankrupt if the investor asks for loan repayment.  

Variations of Convertible Notes

In the USA, simple agreement for future equity (SAFE) and keep it simple security (KISS) have emerged as the standardised versions of convertible notes and are more popular.  

KISS and SAFE agreements were created with the aim to simplify the seed financing process by creating standard form documentation, which means there are fewer points to negotiate between founders and investors. So, the startup receives the funds faster.

The SAFE note was introduced by Y Combinator to facilitate investments by wealthy angel investors in early-stage technology startups. Like the typical convertible note, SAFE may also include a valuation cap, discount rate and qualifying raise.  

Difference Between SAFEs and KISS

The difference is that SAFEs do not contain debt features such as interest rate and maturity date. Hence, SAFEs are not considered debt.

The KISS note was created by 500 Startups to make convertible equity financing even simpler and more flexible. There are two types of KISS; one is a debt version with interest and maturity; the other is a non-debt version like SAFE notes.

Unlike SAFE notes, KISS requires a most favoured nation (MFN) clause. If the startup issues securities with more favourable terms in the future, KISS investors are allowed to adopt the new terms instead.  

Additionally, KISS conversion events and valuation discounts are negotiated on a deal-by-deal basis.  

The benefits and risks of KISS are like SAFE, with the additional benefit of MFN clauses, which makes it even more attractive to investors.  

KISS is full of convertible notes: it has more complexity but is much more balanced than SAFE.  

Conclusion

Convertible notes are therefore financial instruments with discounts, caps and interest rates.  The notes are usually issued or activated upon completion of a new funding round, purchase of a company, or other specified date or maturity. This is often 18 or 24 months after the initial funding. Investors can demand redemptions, convert notes at the caps, or negotiate note extensions, usually if the company can afford it.

Every instrument has trade-offs. Convertible notes are simple and quick but take them with a pinch of salt—use scenario analysis as the litmus test.

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