The convertible note is quickly becoming one of the most effective methods for raising money for a startup, but it may sound more confusing than it is if you’re still just learning about finance. Fortunately, simplicity is one of the principal advantages of a convertible note. Here’s everything you know if you’re considering a convertible note as a form of investment for your startup.
What Are Convertible Notes?
Running a startup means recognizing your leverage – and your leverage is predicated on the quality of your product. Seed financing has become such a major driver in the world of finance that company founders have more leverage than they ever had, but making the most of that leverage is important if you want your company to succeed.
A convertible note is essentially a form of debt – more specifically a loan. The difference is that the payout of the loan comes not in the form of money but in the form of preferred shares during the initial period of share financing. It’s a significantly more straightforward exchange than many other investment options, and that comes with some distinct strengths as well as a few disadvantages.
What Are the Advantages of Convertible Notes?
If your business is just starting up, it can be hard to find an accurate valuation. Since convertible notes are a more basic loan, they can provide a level of early investment that doesn’t overpromise and doesn’t inflate the value of a company based on competition over shares. That ensures strengths to both the business owner and the investors. The former gets more control over the early direction of their company, while the latter gets the assurance of a valuation cap that helps them get in on the ground floor once the company does go public.
Legally, convertible notes are more streamlined as well. They’re easier to document, and you can get them up and running without having to deal with more complicated accounting. That makes convertible notes one of the best choices for smaller startups and for the early stages of the investment process.
What Are the Disadvantages of Convertible Notes?
Using convertible notes for the earliest phases of investment can be advantageous, but it can also shut you out from some investors. Many investors would just rather wait before determining whether to put money into such an early concept – even if that means paying a little more for shares.
But the biggest thing that could scare potential investors off is the lack of control that a convertible note provides them with. Because what’s great for the business owner can be frustrating to investors. Typical shareholder expectations like voting rights, preferences for liquidation, and control rights aren’t afforded to holders of convertible notes, and that means a frustrating period of just watching with no control.
When Should You Use Convertible Notes?
Convertible notes are an especially good choice for an entrepreneur looking to get their startup up and running. It lets owners retain control without immediately having to cede it to shareholders, and it’s a much simpler alternative to a lot of alternative investment options. Investors can benefit from that simplicity as well, and they get a low-risk buy-in for when the company opens itself to shareholders.
As a startup begins to grow, so too will the need for more complex investment options. Still, convertible notes can serve as a solid way to build up quick capital even later on in a business’ life. And as your business matures, convertible notes will become just one in a larger kit of tools rather than becoming irrelevant altogether.
