Commonly used by global accelerators like Y Combinator, convertible notes, also known as SAFE (or “Simple Agreement for Future Equity”), offer a short-term debt that eventually converts into equity.
Basically, if you have an idea and are looking for funding to get your business started, investors or venture capitalists will lend you money to launch your startup.
With time, rather than having to pay the money back with interest, you will provide them with shares of preferred stock, based on the pre-agreed terms of the note.
So the big question is: why would you, as an early stage startup founder, issue a convertible note when you could directly issue shares of common stock to investors instead?
In a nutshell, it is often difficult for the founders and the investors to agree on a company valuation, especially at a pre-seed and seed stage, and as a result, on the percentage ownership the investor will receive for a given amount of money.
But at this stage, given your company is mainly comprised of yourself and your idea, how will you be able to value and sell parts of it to investors?
For example, how many shares and what percentage of ownership would you give an investor in exchange for a $100,000 investment?
The solution is to issue a convertible note.
The mechanism essentially allows issuers to defer valuation negotiations until a future round of equity financing.
When you issue a $100,000 convertible note to a VC, this amount will act as a loan – for the time being.
Then, after a year or two, when your venture grows into a veritable company, with a lot more data points and insights, you will be able to value your startup more rigorously, and will be ready for another round of funding.
At this stage, the VC firm that had initially lent you $100,000 can obtain it back, in the form of shares in the company.
That way, both you (as the entrepreneur) and the VC can skip the risk of incorrect company valuation that could have adverse consequences on later funding rounds.
Convertible notes are speedy, simple and cost-efficient.
Issuing shares of stock is complex. It can take weeks to negotiate all the terms and documents - not to mention legal fees.
In contrast, you could close a convertible note round in a day or two by issuing a 2-3 page promissory note.
Another great advantage of issuing convertible notes: you avoid giving holders any control.
Typically, when they receive shares of stock, investors are granted certain significant control rights, including a board seat and veto rights with respect to certain corporate actions.
Convertible noteholders are rarely granted control rights, and have little power to sway the outcome of their investments. This leaves more control rights for the founders.
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