What is a Convertible Note?

Despite prodigious growth for years, tech investment hasn’t slowed down an iota, and that seems unlikely to change anytime soon. That economic boom is good for just about everyone, but it’s especially good for smart startup founders. The level of demand – and the opportunity for a success on the scale of the next Google or TikTok – means that founders have more leverage than ever before. And while there isn’t a singular investment method that’s going to be right for every startup, convertible notes are one of the more promising options. Here’s everything you need to know.

A Promise That Gives Founders More Control

An inaccurate valuation can be the death knell for a young startup. If it’s valued too low, you can’t get the resources you need to get your project off the ground. If it’s valued too high, it’s very likely that you’ll be setting yourself up for expectations that you can’t reasonably meet. Convertible notes skirt that issue by sidestepping the issue of a valuation entirely. There’s a lot of instances where that can be game-changing. Consider how many startups began as simply an idea, or how many have turned into giant businesses that continue to be highly successful presences while still not returning profits years later.

Convertible notes aren’t investments. Instead, they’re simply loans, but loans that are paid back as equity in the company. A convertible note will also typically come with interest which is then paid back to the investor as equity as well. The valuation will then happen in preparation of the first round of financing, where the person who invested in the convertible note will be given preferential treatment for investors. And while an investor won’t get the same sort of control they might with stock straight out of the gate, a convertible note comes with some distinct advantages. 

Primary among these are the valuation cap and discount rate. The valuation cap increases the likelihood of generous investment for startups that find momentum early. It creates a ceiling for the price of equity conversion and in doing so can provide a huge payoff for convertible note investors. The discount rate offers an extra incentive for investing early by giving convertible notes priority in the first round of investment.

The Advantages of a Convertible Note

Pushing the question of valuation down the road while your startup gets its footing is a huge benefit in its own right, but it’s only one facet of an increasingly popular form of fundraising. For one, it gives the founder a whole lot more freedom to run their company the way they want. Since the convertible note transaction is purely financial, you don’t have to worry about losing control of your company’s decision-making to early investors who negotiated for preferred stocks. That’s especially worrying early in the life of a startup’s career. The last thing you need is your passion project being overtaken by vultures who are simply looking to pump and dump their stocks.

Moreover, convertible notes are a great choice simply because of how simple they are. There are really only two factors to consider – the valuation cap and the discount rate – and that means that you won’t have to spend long and complex negotiations figuring out exactly what stock preferences each investor will get. It also does away with – or at least forestalls – the need to negotiate a valuation.

All told, convertible notes are a great choice for startups who are still figuring out the essentials. It can also be a good complement to a more robust and traditional valuation and investment cycle. A convertible note is just one of many ways to draw investors to your startup, but it can be one of the most valuable when utilized correctly.

Ulani Uriah

Umar Nisar was born and raised in the busy city of Abbottabad. As a journalist, Umar Nisar has contributed to many online publications including PAK Today and the Huffing Post. In regards to academics, Umar Nisar earned a degree in business from the Abbottabad UST, Havelian. Umar Nisar follows the money and covers all aspects of emerging tech here at The Hear Up.

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