Understanding Convertible Notes
It is becoming less and less common for investors to invest in companies in exchange for equity ownership. It is simply too difficult to value the average startup company that hasn’t even gotten its product or idea to market yet, let alone generated a profit. Since virtually all the conventional valuation methods are based on the assets, earnings or cash flow of an operating company, it is difficult to place a value on a company that owns little more than a unique idea for a product or a new way of doing something.
To combat the problem of valuing a startup when the investment is made, angel investors typically prefer to invest using a convertible note. A convertible note generally provides for a fixed interest rate (typically in the range of 5% to 10%) and a maturity date (typically 12 to 18 months from the date of investment). A convertible note can be secured or unsecured (although the typical assets of a startup don’t make for great collateral).
Unlike a conventional promissory note, the holder of a convertible note has almost no expectation of being paid back during the term of the note. Every convertible note will provide for specified circumstances that trigger conversion of the note into equity in the company. The most common triggers for conversion are (i) a Series A transaction whereby the company raises more money from a venture capital group in exchange for equity, thus setting a valuation for the company; and (ii) the maturity date of the note.