Most burgeoning entrepreneurs, and even casual Shark Tank viewers, will likely understand the process of taking investment capital, but the actual process is a little more complicated than a five-minute TV show segment might reveal. A less publicized but no less viable option is the Convertible Note–a simpler, speedier, and perhaps more cost effective alternative to common stock investment.
This first installment of a series of blog posts will elucidate the Convertible Note as an investment option and will explore the benefits Convertible Notes offer to the entrepreneur.
Can Someone Define “Convertible Note” Already?
Simply put, a Convertible Note is a short-term loan from an investor to a startup. Rather than cashing out on the investment with interest, the debt becomes equity in a company after the Series A round of funding a startup. Essentially, investors will loan money to the founders of a company in exchange for preferred (not common) stock in a startup.
*We will explore the differences between preferred and common stock in a subsequent blog post. For now, it is important to understand that common stock is considered a riskier, less beneficial investment than a preferred share in a company.
Why Company Founders Should Explore The Convertible Note
Fair Valuation
While there may be a few practiced and methodical “sharks” capable of giving a quick and rarely fair valuation of a company, many founders find the valuation process challenging; before your company is fully mature, your company might become diluted by an unfair valuation. The Convertible Note allows the founder to delay valuation until the company is more mature and has more data points to validate a better valuation.
Cost and Ease
At its initial phases, building a company is already a timely endeavor demanding much of the founder’s attention, and early investment can be a lengthy and expensive legal process. Rather than spending upwards of $10,000-$30,000 on legal fees and spending weeks in negotiations for initial investment, the Convertible Note is an easily negotiated 1-2 page document that allows for funding at the crucial initial phases of the company without the distraction of negotiation with investors.
Control
As opposed to simply granting preferred stock to your investors, a Convertible Note grants founders more ways to stipulate who has control over the company. Even though noteholders eventually obtain preferred stock, noteholders obtain control significantly less often than preferred stockholders who initially invest in the company, particularly when it comes to mandatory board seats.
With a cursory understanding of the Convertible Note, founders can begin exploring the best path garnering investors for their unique company. Subsequent blog posts will explore:
- Drawbacks to the Convertible Note, and precautionary advice
- Technical Explanations of the Convertible Note
- Convertible Notes from an Investor Perspective
If you have further questions, don’t hesitate to reach out to one of our rock-star outsourced CFO’s to the right.
