Many startups and investors agree to use convertible promissory notes to facilitate early stage investing. As with any investment scenario, there are advantages and disadvantages to this approach.
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What is a Convertible Note?
It is a simple promissory note, usually bearing interest and payable at some future date. The unique aspects of a convertible note are:
- It converts into equity in the company so long as certain agreed metrics are achieved
- Conversion rather than repayment is the usual intention of the parties
- The usual metrics for conversion (a “conversion event”) could be some or all of:
- Later financing acquired of an agreed minimum level;
- Developmental milestones reached by the company; and/or
- Strategic partnerships concluded with important companies;
- The conversion into equity is usually at a valuation that is consistent with the valuation agreed to with investors in an investment round that occurs at a later time.
What are the Benefits?
- Avoids a valuation dispute between founders and the convertible note lenders
- Brings founders and convertible note lenders onto the same side of the table in determining valuation with later investors
- Can be concluded and transacted relatively quickly
What are the Drawbacks?
- If the conversion event doesn’t occur, the note remains due
- If the note isn’t paid off, the convertible note lenders may be able to foreclose on the company’s IP or other assets
- The company doesn’t have a “demonstrable valuation” that has been agreed to in an arms’ length financing transaction
Growthink is a investment bank (FINRA, SIPC) that assists privately-held firms with convertible note and private placement offerings. Since 1999, Growthink has developed business plans, convertible note agreements, and private offering memorandums for hundreds of businesses. Our clients have raised more than $1 billion in private financing.
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