A convertible note is a type of debt financing that allows investors to loan money to a company in exchange for the option to convert their loan into equity at a later date. This type of funding is often used by early-stage companies that have not yet reached a point where they can issue traditional equity.
Here are five features of convertible notes:
1. Convertible notes have a maturity date: The notes are typically issued with a maturity date of one to three years from the date of issuance. At the maturity date, the company will either have to pay back the loan or convert the notes into equity.
2. Convertible notes have a conversion price: The conversion price is the price at which the notes will convert into equity. This price is typically set at a discount to the price of future equity rounds.
3. Convertible notes accrue interest: The notes accrue interest at a rate that is typically lower than the rate for a traditional loan.
4. Convertible notes have a cap: A cap is the maximum valuation at which the notes can convert into equity. This cap is typically set at a higher valuation than the current valuation of the company.
5. Convertible notes are typically used by early-stage companies: Convertible notes are often used by companies that are in their early stages of development and have not yet reached a point where they can issue traditional equity.
It’s worth noting that the terms of convertible notes may vary depending on the company’s situation, the stage of the company, and the investors.
A hypothetical scenario where a convertible note is used.
A startup company, called “ABC Inc.” is looking for $500,000 in funding to help them develop their product and expand their team. They decide to issue a convertible note to a group of angel investors.
The maturity date of the note is set at 18 months from the date of issuance.
The conversion price is set at a 20% discount to the price of the next equity round.
The interest rate on the note is set at 5% per year.
The cap is set at $5 million, which is higher than the current valuation of the company.
The angel investors loan $500,000 to ABC Inc. in exchange for the convertible notes. The company uses the money to develop their product and expand their team.
After 18 months, the company has made significant progress and is ready to raise more funding. They hold a Series A round and are able to secure a valuation of $10 million. At this point, the angel investors have the option to convert their notes into equity at a 20% discount to the Series A price. So, the conversion price would be $8 million (10 million * 0.8). Since the cap is set at $5 million, the angel investors can convert their notes into equity at $5 million.
It’s important to note that this is a simplified example and in reality the terms of convertible notes can be more complex depending on the company’s situation, the stage of the company, and the investors.
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