Thankfully for startups, seed investment can come from many different places these days. Angel investors, incubators, and venture capital funds are everyday occurrences that you’re likely to be familiar with. And you probably already know that traditional seed investors have received cash plus interest or a major stake in the company (or some combination thereof) in exchange for their moolah.
Investors of all types are practically throwing money around these days, flailing their financial arms in search of connecting with the next Facebook, operating under the typical arrangement of exchange funds for some profit and a percentage of perpetual control.
While that may come as music to the ears of many would-be founders (like all those fledgling entrepreneurs on "Shark Tank,") you might be inclined to shy away from giving up control in your startup in the process of securing seed investment.
If maintaining control is a big issue for you, you might want to consider convertible note seed funding to help you get your startup running. A convertible note is a great solution for many, though it introduces some specific risks for founders and investors alike. Nevertheless, the convertible note is a popular model for securing seed capital and it may very well be the solution for you. If nothing else, it’s another avenue through which you can potential secure investment, and that’s the name of the game when you’re starting up.
Let’s take a closer look at convertible debt, as well as how a convertible note template can come in handy.
Wait, what is a convertible note, eh?
BusinessFinance.com says a convertible note “is a debt instrument that can be converted into stock at the option of the holder or issuer.” In reference to a startup, a convertible note is a loan agreement wherein the initial funds become debt, allowing the investor to purchase stock when the debt matures, for a discounted rate, cashing out the debt for shares. A typical convertible note will have a date of maturation, often 12 months from the time of issuance, but generally just after the anticipated conclusion of Series A funding.
Perhaps the best reason to consider securing investment with a convertible note is that it’s a loan, not an investment, allowing you to skirt around some paperwork. Still, there can be hurdles to overcome in the process. Some investors place special demands on convertible notes to address the inherent problems with valuation in young startups, such as placing a conversion value cap on the transaction.
That means if you and the investor agree to a post-Series A valuation of $3 million, but you actually secure $6 million, the investor has the option to buy shares at half-price. That can rapidly add up to the investors effectively seizing control of your company right out of Series A funding, so a word of caution there. Another thing to keep in mind if you are considering approaching an investor about a convertible note is that, if you fail to get to Series A, you still have to pay the money back.
But convertible notes have certainly helped many startups get going, and if you’re business outlook is looking particularly bright, it can be a great option for you, too. Tesla Motors has been a convertible note success story, recently using proceeds from the upsized sale of its convertible debt to pre-pay Department of Energy loans the company had used to fund the research and development of its Model S sedan. Well played, Elon Musk; well played, indeed.
How to send a convertible note
Once you’ve decided that a convertible note is good for your startup, you are faced with the task of tendering it to your would-be investor, negotiating the terms, and signing the agreement. This can be an intensive (and nerve wracking) process as you and the investor hash out the details – like the aforementioned conversion value cap – and hammer out the deal.
Since the convertible note is not an investment, you can save on legal fees and dispense with some legalese by tendering a loan agreement and working through it with your prospective investor directly. Using a tool like PandaDoc, you can send, track, revise, and ultimately sign your convertible note in the digital realm. The whole process can be done paper-free, in the cloud, and still be a binding agreement.
Forging an agreement for convertible debt seed funding isn’t rocket science, mind you, but of course you’ll need to get your legal and finance departments in the loop to cover your asparagus, if you catch my drift. But the legal expense savings can be substantial. Whereas the issuance of preferred stock can cost tens of thousands of dollars, the cost involved in executing a convertible promissory note can be as little as $1,000 - $2,000 in many circumstances. That leaves you with more capital to grown your business with.
What goes into a convertible note?
The basic idea in creating a convertible note is to outline for the parties involved (you and your investor) all of the terms of the deal and collect signatures from each person. Sounds simple enough, right? Outwardly, there’s not that much difference in a convertible note and a loan between friends. But, because most investors will want to protect themselves from risk and get the most out of the deal, the convertible note document itself can get complicated.
If your agreement is going to have a conversion value cap, or the risk of defaulting on the debt is more than remote, the contract will need to address all of those points. Without delving into legalese too much, let’s look at the basic structure of a convertible note. Of course, if you’re ready to sign and go, check out our free convertible note template right over here.
The convertible note template has the same basic parts as many other loan agreements, such as:
A listing of the parties involved (your startup, the Company; the investor, the Holder)
A sub-section detailing issuance
A sub-section outlining the terms of the sale of the notes and purchase of stock
A sub-section stating any and all warranties and guarantees on the part of the Company
A sub-section stating any and all warranties and guarantees on the part of the Holder
A sub-section facilitating repayment in the event of default prior to Series A
A sub-section covering the terms of the eventual conversion of the debt
A listing of any miscellaneous clauses and/or notices
A signature line for both parties
You can use our convertible note template or create your own based off of it, depending upon your specific needs. I’ve also seen several smaller loan amounts make use of considerably simpler convertible promissory notes, so that’s something to keep in mind if the investment you seek is particularly minor.
If you wind up pitching to a room full of investors, you can personalize the convertible note template for each and follow with it after the pitch. It’s a good idea to use a template because you can secure as many loans as you’d like (and are able to) and the language of each agreement will mostly stay the same from one loan to the next.
Is a convertible note the right move for your business?
The convertible note has been widely praised in the past few years, with industry pundits like AngelList co-founder, Naval Ravikant, declaring, “Convertible notes have made variable pricing possible.” This gives founders an advantage when it comes to rounding-up investors and finishing out seed funding. It’s an ace up your sleeve, really.
If you’d like to herd in investment using convertible debt, there’s no reason you can’t also accept traditional seed investment from other investors – just keep in mind that when it’s disclosed, the discount offered to convertible note investors upon maturity of the debt might offend the traditional investors of your business. All in all, though, convertible debt is one option of many in the seemingly ever-improving world of startup finance. After all, if it worked for Elon Musk, who wouldn’t want to give it a shot?
Have you used convertible debt to secure seed investors? Do you think it’s a good or a bad thing for founders?