A convertible note is a type of short-term debt which transforms into equity, generally in conjunction with a future financing round; essentially, the investor would be loaning money to a startup and rather than a return in the form of principal plus interest, the investor would gain equity in the company.
The main benefit of issuing convertible notes is that it does not force the issuer and investors to establish the value of the company when there actually may not be much to base a valuation on, in some instances the company may just be an idea. That valuation will generally be calculated at the time of the Seed or Series A round of financing, when there is more data available to base a valuation on.
Convertible Note Conditions
When assessing a convertible note, there are a few key conditions that must be considered:
Interest rate
As you are loaning funds to a company, convertible notes usually accumulate interest. Though instead of being paid back in cash, this interest accrues to the principal invested, increasing the amount of shares issued upon conversion.
Discount Rate
This represents the valuation discount you receive relative to investors following the financing round, which rewards you for the extra risk you took on by investing earlier.
Valuation Cap
The valuation cap is an added reward for bearing risk earlier on. It essentially caps the price at which your notes will convert into equity and in a sense provides convertible note holders with equity-like advantage if the company kicks off right away.
Maturity date
This indicates the date on which the note is due, the time that the company needs to repay it.
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