How Does A Convertible Note Work?

A Cornerstone of Regulation Crowdfunding

Convertible notes are a form of debt that converts to equity over time; said simply, convertible notes allow investors to loan money to a startup or early stage venture and receive equity in return, instead of their principal loan plus interest.

The greatest advantage of convertible notes is that investors and the note issuer do not have to finalize a valuation of the company at an early stage, which is especially important for companies that don’t have comprehensive data or time that allows an accurate valuation. Instead, investors “loan” their money to the business and in return will receive equity when an event, such as a future financing round, where the company’s valuation becomes more concrete. This type of security is very popular with Silicon Valley technology companies that have great interest from angel investors at an early stage, but lack the ability to make a proper valuation of the company’s worth.

Investing In A Convertible Note

So you’ve identified a compelling company that’s offering the sale of convertible notes for early stage fundraising. You’re interested in purchasing one or some of these convertible notes, but where do you start? It’s important to understand the terms of a convertible note before you invest.

Here’s the main aspects of a convertible note to know before you make any investment decisions.

Discount Rate

The discount rate represents the discount that you receive when purchasing a note relative to investors in a later round of funding, compensating investors for their additional risk taken by investing at an earlier point.

Valuation Cap

The valuation cap is an extra bonus for taking on risk by investing early. This tool limits the price at which your debt notes convert to equity, allowing investors to receive a greater return on their investment if the issuing company grows quickly.

Interest rate

As a convertible note acts as a loan from you (the investor) to the company issuing the note, there will be interest that accrues on the principal amount you invest. Instead of being paid out to investors in cash, this accrued interest converts to equity, increasing the total number of shares the investor receives upon the note’s conversion to equity.

Maturity date

This is the “due date” for the convertible note, signifying the date on which the issuing company must repay their investors.

Why Purchase a Convertible Note?

Convertible notes allow you to invest in early stage companies and projects that you believe have the opportunity to grow exponentially. By getting in at the ground floor and purchasing a convertible note, individual investors stand to earn a higher return on their investment. Whereas investing in early stage startups and projects has historically been off limits to the wider public, Regulation Crowdfunding now allows almost everyone to invest in companies that have the possibility to grow exponentially. Convertible notes carry risk like all forms of investing, but offer early investors bonuses for their willingness to accept this risk. As many companies and projects in the climate space are young and need funding, convertible notes provide a simple way for these businesses to raise capital that they desperately need, while offering their early believers a way to get them off the ground.

Originally published at https://www.koreconx.com on April 29, 2022.

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