“Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” Paul Graham, the father of startups and the founder of Y Combinator stated this in a tweet in 2010. In the US, notes are an effective standard for seed-funding startups. More and more European startups are adopting the practice and realising the benefits of convertible notes.
We’ve asked Rutger Kemper, an experienced Angel Investor who recently joined our team at Leapfunder, to share 4 benefits of raising funding via convertible notes.
Benefits of Convertible Notes
1. Valuation is postponed to a later stage
When using convertible notes, the whole valuation discussion is postponed. With the convertible note, the startup is able to raise financing and use that financing to get the product/service into the market. The startup is able to get a track record – revenue/or milestones – so when a large investor – VC or strategic investor – wants to invest, the valuation will be based on more than pre-revenue assumptions. The valuation will be more realistic. At the time a large investor – VC -invests, the notes will be converted into shares and the early investors will be rewarded for the risk of early investment. No valuation discussion means a higher chance of closing a successful financing round.
2. Quick to close the legal deal, with less legal costs
When you are looking for different sources for investment, such as business angels or venture capitalists, it can be challenging to close a deal. Different parties have different demands and different preferred legal structures. A convertible note is an accepted standard and relatively easy to get agreement on. The contract is usually just between the startup and the investors: there is no notary involved, so everything is much quicker and cheaper. Convertibles are known to be agreed and closed within a week, while an equity deal can easily take several months.
3. A standard for seed investment for years
Convertible notes are financial products which have been at the heart of the startup scene for years. Usage of the convertible note is common worldwide in a variety of situations. In the US, notes are an effective standard for seed-funding startups. In Europe, they have been in use with VCs for years, and the general public is quickly learning about this financial tool. It is one of the default choices, next to shares, for startup financing and the web is full of sites that simply explain the note for new users. These sites are mostly aimed at the US, where note investing is the norm. The economics are the same in Europe, and investors here are quickly adopting the tool as well.
4. Advantages for early investors
A convertible note can have several different reward mechanisms for early investors. A straight equity deal only delivers a profit if the shares go up, and delivers a loss if the shares go down. A convertible note can deliver a return to the investors in many different ways: a positive return upon conversion is pretty much guaranteed, making it much easier for the investor to take the plunge and invest. First, there is the interest on the note, this can be accumulated and converted to shares so it does not have to be paid out in cash periodically. Secondly, a discount on the share price is offered when the convertible converts into shares. This means that when a note converts, the noteholders get an automatic reward for the risk they took in the form of a discount on the shares. Finally, there is often a cap, which represents an agreed maximum pre-money valuation at conversion. This makes sure that when a startup is extremely successful, the investor will benefit additionally from that success. This creates a win-win situation for both startup and investor: the investor has a high chance of a positive return, while the startup has a higher chance of securing the deal.
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