As with any business, early-stage companies have the option to either raise funds through equity or debt. While both the mechanisms have their own set of pros and cons, convertible notes offer a hybrid solution to match the needs of early-stage investing.
In a way, they work as short-term loans to the company for which the investors receive interest payments. However, under predetermined conditions, interest converts into equity. The predetermined conversion event is generally a future round of funding or exit event.
Metrics to Consider
It goes without saying that investors must exercise caution and perform their own due diligence before deciding to invest in convertible notes. Here are the primary aspects that need to be looked into:
- Valuation Cap: It is important for investors to be careful of the valuation cap mentioned in convertible notes documents. It will help protect them against dilution of stake due to future rounds of financing.
- Discount: Being granted a discount is another important factor. It determines the discount rate that the early-stage investors will receive for investing in future rounds of financing, as a reward for investing early on in a risky venture.
- Interest Rate: Since convertible notes are a type of loan, investors must look at the interest rate being offered. In the case of crowdfunding, interest accrues and converts into equity instead of cash.
- Maturity Date: It is the date on which the note is due and needs to be repaid by the company.
Pros of Convertible Notes
Convertible notes are the most common methods of investing in early-stage companies. They are simple and uncomplicated, and they offer the “best of both worlds.”
Investors investing in these notes receive an interest payment, along with becoming an equity stockholder in the company upon conversion. Valuation cap, discount rate, and interest protects the rights of convertible note holders
Convertible notes are ideal instruments for investors willing to take the risk of investing in a startup without getting involved in the complications of valuations. At this time, despite lacking metrics to value the company which some investors consider risky, high risk means high rewards.
Cons of Convertible Notes
Some of the pros surrounding these notes causes speculation among certain investors. For instance, drawbacks include uncertainty associated with valuation. In the instance of an unvalued company, investors consider the lack of information surrounding the terms unfair. Therefore, some investors wait for a priced round to determine the value of the company before investing in convertible notes.
In addition, convertible note holders do not have voting rights, ownership rights, or pro-rata rights as they do not yet own equity.
Whether or not to invest in convertible notes depends on individual investors’ risk-appetite and personal preferences. If startups willingly forego rights associated with equity ownership and face risks associated with debt financing, such notes turn out to be profitable forms of investment in numerous cases. There is a reason they have emerged as a preferred method of investing in the crowdfunding market.