A convertible note is a method used by a startup company for their investments. A startup company may not be able to sell their shares in the stock market, during the early stages. So there must be a way to gain investments and funding for the company to establish itself in the market. Here comes the use of Convertible note. It is nothing but a short term loan that will be converted into shares in the future.
Why Start-Ups go for Convertible Note?
The funding or loan for setting up a company cannot be easily acquired from larger investors who wish to issue capital for startups. With Convertible notes, the exact tenure of investments are not, so the company is free of any pressure and can operate easily to gain an economic value and operating history for them.
Convertible notes has two important key parameters;
Valuation cap: This defines the maximum value of equities that can be generated from the investments made through a convertible note. For example if a company has a convertible note of 2 million during their start up and the company manages to raise their economic value to 10 million, then they will issue shares to their investors who helped them raise 2 million. The maximum share that is to be given to them is set by the valuation cap.
Conversion discount: It is the percentage discount in the convertible note that a company can offer while issuing their shares to the investors. They are set to approximate the amount of risk taken by the investors while giving a convertible note to a startup. It generally ranges between 10% and 35%.