As an early stage startup is ready to raise money, but its valuation has not yet been determined, a convertible note can serve as a good fundraising option.
A convertible bond is a debt instrument that is usually converted into equity at a later date. Investors who invest in a note are essentially lending money to the startup, but instead of getting their investment back as dollars with interest, they get it back in the form of equity once a valuation is assigned in a later fundraising round.
This approach has a number of advantages for both the company and the investors. Convertible bonds allow companies to defer valuation until an equity financing round, giving them more time to build and flesh out a product. And for investors, while riskier than the traditional financing route, convertible bonds offer them the opportunity to get more equity for their money than waiting until Series A.
How do you know if convertible notes are right for your startup?
One advantage of convertible notes that founders should not overlook is that they usually do not contain any control or board seats.
Convertible notes work best for early stage businesses, especially pre-revenue startups. That could be a company that has a solid proof-of-concept – a product proven to work at its current scale or a medical device in the early stages of applying for FDA approval.
In either case, the companies build their value and the dollars they raise with a convertible note help them scale. The end result is that when they are ready for an equity financing round, they already have a higher pre-money valuation than they would otherwise be.
When financing a convertible bond company, investors look for huge upside potential. The best-case scenario is when the company eventually has a significantly higher-than-expected valuation by the time it gets into Series A.
Convertible bonds typically contain a valuation cap so early investors don’t lose if the company’s value skyrockets for a Series A. When the bond is converted, investors gain more equity at the valuation cap price and share the benefits of the increased value of the company.