Angel Investing: Why Are Convertible Notes The Better Option For Startups

What Is Angel Investing?

Angel Investing has an Angel Investor or Private investor or Seed investor or Business angel who is the owner of a huge estate and provides finances to startups in exchange of ownership equity in the company. Oftenly, this angel investor is someone from family or friends. The investor invests the money either at the beginning of startup or helps financially when the company is going through a hard time.

Angel Investing

What Is Convertible Note?

Convertible Note is a debt security (lended money) which can be converted into the ownership equity of the company. The process of convertible note is that the money lended, automatically converts into the same amount of stock and that is owned by the angel investor. The main terms that should be considered while defining the value of a convertible note are -i) Discount rate – is the reduction percentage at which the convertible note will convert in the valuation round. ii) Valuation cap – this converts the invested amount into equity at a maximum price. iii) Interest rate – this is the rate that gets issued till the notes are converted into equity or the company has to pay back. iv) Maturity date – this is the day when the company has to repay the investor either with the notes that have been converted to shares or have to pay back the debt money with the interest. The main advantage of convertible note can be that the money receiver won’t have to pay back the money with interest and the valuation of the company can not be conducted when it’s just a mere idea.

Why Is Convertible Note Better For Startups?

Following points might help you know a bit better about convertible note: –

  • Valuation can be delayed:

    Until there are no products, no customers, no sales in the company, the valuation can not be done. Further, the valuation can be shifted from one time to another once the company is doing well in the market.

  • Protects the investors

    It keeps the investors close to the company as the investors will not leave the company until the valuation is done. And permanent investors may help again if the company faces any kind of loss.

  • Low Valuation

    As the amount of debt is more so the company would be able to justify the lower valuation of the company.

  • Closing is quick

As the valuation is delayed so often the investors negotiate the valuation or deal                 document and they agree to the terms and conditions in one go.

  • Lower legal fees

As the convertible note is not as vast as traditional convertible preferred stock                    financing,  so the legal fees of convertible note is less than the other. Where the                  convertible note is of 10 pages, the traditional convertible preferred stock financing is of      100+ pages.

Pros And Cons Of Convertible Note

 Pros

  • Raising a convertible note to the investors leads in increasing the duration of valuation. This results in sharing less stocks from the company.
  • As convertible note is simpler to document from a legal perspective, it is cheap and is easy to close more quickly.
  • The funding of the business is fast and simple. The investors invest right at the beginning and the process is pretty simple too.

Cons

  • The major disadvantage is giving up equity. If you don’t want to give your stocks to your investors, then you should not go for this option. Rather you can choose the SPV for your business.
  • Risk of the startups increases if they are not able to raise the sales or the stocks. If the note matures but does not convert, the company has to pay the debt amount along with the interest. To avoid these situations, every company must have CAP tables to keep the records. Another benefit of this is that sometimes the other investors like to willingly invest after studying the CAP table or spreadsheet.

Startups with high growth phases should go for convertible notes. After the investment      by the angel investor, the company should prepare themselves for valuation so that the      convertibles won’t concern them. In the end the convertible notes are debt and the            company will need rapid growth in order to increase the value for investors. If this              doesn’t happen before the note matures, then the company would have to pay the debt      amount along with interest until and unless the investor pardons you with some extra        time.

FAQ On Convertible Note

Q. What Is Convertible Debt?

Ans. It is a kind of funding to the startups as a loan and instead of paying back the loan, the lender or investor becomes a part of the company.

Q. What Happens If The Note Is Matured And The Valuation Is Low?

Ans. In such a scenario, the company has to give back the debt amount along with the interest.

Q. How Much Is The Interest?

Ans. Before it was 7% – 10%, but now it has come down to 1% – 2%.

Q. Who Can Go For Convertible Debts?

Ans. Startups with a way of growing rapidly can consider this way of funding.

Conclusion

Choosing the right way of funding is the major step for startups. Before making a decision, research well about every kind of funding. Go through their advantages and disadvantages, compare them and whenever in doubt always take help from professionals. Convertible notes are healthy for a startup business, but the company must grow in order to make it beneficial. The main terms of the convertible notes such as – Investment and purpose, Interest, Conversion Events, Exit event, Qualifying round, Maturity, Conversion Price, Valuation Cap, Default events should be kept in mind and you should get a vivid idea about each one. For further knowledge, you can also consult with a lawyer. Also go through some examples of convertible notes to clear every doubt. If you are not sure about the growth of your company, then you probably shouldn’t do this.