When it comes to raising funds for a small business, entrepreneurs often face a daunting array of financing options. One lesser-known but increasingly popular option is a convertible note. A hybrid between debt and equity, a convertible note can offer unique benefits for both businesses and investors. But is it the right choice for your small business? In this blog post, we explore the key features, advantages, and potential drawbacks of a convertible note.

What Is a Convertible Note?

A convertible note is a loan agreement that allows investors to provide funding to your business, with the option to convert the debt into equity at a later date, typically during a future financing round. Unlike traditional loans, convertible notes often come with features like:

• Conversion Discount: With a conversion discount, investors receive a discount (e.g., 20%) on the valuation of the business when the note converts to equity. The conversion discount is a percentage reduction on the price per share that the convertible noteholder will pay when the note converts into equity. This discount compensates the investor for the risk they are taking by investing before the business has reached a valuation event, such as a Series A funding round.  For example, if the Series A investors purchase their shares at $1.00 per share, the convertible note investor would convert its debt and acquire its shares at $0.80 per share, assuming a 20% conversion discount provision is included in the convertible note. 
• Valuation Cap: A valuation cap sets a maximum company valuation at which the convertible note will convert into equity, regardless of the actual valuation at the time of the triggering event (ie., the Series A funding round). A valuation cap protects the convertible note investor by guaranteeing that they won't be priced out of equity ownership if the company's valuation increases significantly before the note converts.  For example, assuming the convertible note contains a $5 million valuation cap, if the company raises its next funding round at a valuation of $10 million, the noteholder's equity will be calculated as if the company were valued at $5 million, and not at the $10 million actual valuation.  This will result in the investor receiving a larger pro rata equity stake in the company than they would absent a valuation cap. 
• Deferred Interest: Convertible notes accrue interest like a typical loan, although the interest is often added to the principal and converted into equity upon the conversion of the note.

When structuring a convertible note, it's crucial to strike a balance:
•    A lower valuation cap and higher discount attract investors but can dilute the founders' ownership significantly.
•    A higher cap and lower discount reduces dilution but might make the terms less appealing to early investors.

Advantages of Convertible Notes

1. Simplified Fundraising Process.  Convertible notes are often quicker and less expensive to negotiate than issuing equity. This makes them particularly appealing for early-stage businesses that need funding but don't want to spend excessive time or money on legal and accounting/valuation fees.
2. Defers Valuation. Determining the value of an early-stage business can be challenging and contentious. Convertible notes allow you to delay a formal valuation until a later round of equity financing, when your company's value may be clearer.
3. Attractive to Investors. Convertible notes provide investors with upside potential through equity conversion while also offering some downside protection as a debt instrument. The inclusion of a discount or valuation cap can make the investment more appealing.
4.  Flexibility.  Because the terms of a convertible note are highly customizable, they can be tailored to meet the needs of both the business and the investor.

Potential Drawbacks of Convertible Notes

1. Risk of Misaligned Incentives. If not carefully structured, convertible notes can lead to conflicts between the business and its investors. For example, investors may push for terms that prioritize their conversion rather than the long-term health of the business.
2. Dilution Risks. When the note converts into equity, the ownership percentage of existing stakeholders, including founders, will be diluted – and potentially significantly diluted. It's crucial to plan for this and consider how it impacts your control of the business.
3. Complexity in Future Rounds. While convertible notes simplify early fundraising, they can complicate future rounds if terms like valuation caps and discounts create disparities among investor groups.
4.  Debt-Like Obligations. Until conversion occurs, a convertible note remains a liability on your balance sheet, which could impact your ability to obtain other forms of financing.
5. Call Feature.   Depending on the terms of the convertible note, the investor may have the right to call the note due and payable upon its stated maturity date or upon the occurrence of an event of default, in lieu of converting to equity.   If the note is called, the company must repay it pursuant to its terms, which may not be financially feasible for the company, or may cause liquidity issues.   
   

Is a Convertible Note Right for Your Business?

A convertible note can be an excellent option for businesses looking for fast, flexible financing without the immediate need to establish a valuation. However, it's not a one-size-fits-all solution. Consider factors like your business's growth stage, the amount of funding needed, and your long-term goals before deciding.

Final Thoughts

Navigating the world of small business financing is no easy task, and choosing the right structure for your capital needs requires thoughtful consideration. Convertible notes can provide a valuable bridge to future growth, but they also come with unique risks and complexities. Consulting with an experienced business attorney can help you understand whether a convertible note aligns with your business goals and ensure the terms work in your favor.

At the Law Office of Jennifer M. Settles, we guide founders through financing decisions with clarity and confidence. Contact us today at (602) 617-3938 or www.jsettleslaw.com to learn more about how we can support your journey to success!

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