What is a convertible note and why would your startup be interested in it?

What is a convertible note and why would your startup be interested in it?

It is common that the instruments to finance a startup are diverse to try to provide solutions to the different difficulties and the variety of scenarios that can affect a project.

Within the financing formulas, the phenomenon of convertible notes and their popularization in recent years is particularly noteworthy.

Below, we explain the main legal aspects to be taken into account with the convertible note contract.

What are convertible notes?

Convertible notes or also known as convertible loans are short-term financing instruments that include a provision in favor of the investor to convert the borrowed capital into shares of the company. This contract establishes a series of clauses to articulate the investor’s right to transform the borrowed money into shares of the company after a certain period of time has elapsed.

How do convertible notes work?

To understand how convertible notes work, we must begin by distinguishing the figure of the lender from that of the investor. In the case of convertible notes, as these enable the payment of the debt by means of shares given to the investor, they have a series of particularities different from those of the loan.

While a loan only generates favorable interest for the lender, a convertible note gives an additional right to the investor, allowing the capital to be converted into shares of a business project, which can exponentially multiply the initial investment.

The convertible note operates differently from a conventional loan, as it includes specific stipulations to make the conversion of the loan possible. For this reason, it is important to delimit a term and a series of elements that make it possible to understand how many shares are equivalent to the money lent with the corresponding interest.

It is especially important to know the content of this type of contract in order to understand how it works.

What is the content of a convertible note?

First of all, the convertible note must indicate the exact amount of money being invested. It must show the amount borrowed by the investor.

Naturally, as with any loan, a series of interests will be generated in favor of the investor, which must also be indicated in the content of the convertible note.

Additionally, it is possible that the convertible note includes some type of discount for the investor, that is to say, on the valuation of the company and therefore, of the shares, a discount will be applied to the total price, allowing the investor to obtain a greater amount of shares. This works as an incentive for the investor who is betting on the business project.

It is usually important to add a valuation of the startup prior to the investment or at least a valid mechanism accepted by the parties to estimate the valuation of the company. This is often the main aspect to be negotiated between the parties.

In any case, the valuation of the startup will determine the amount of total shares to which the investor will be entitled, so that a lower valuation at the time of contributing money translates into a greater number of shares and vice versa.

One aspect that may be advisable to include is the total capital that the startup intends to raise. This figure will allow to have a real knowledge of the economic situation of the project, so it is usually a section to be included in the convertible loan note contract.

Last but not least, it will be necessary to determine the term for executing the conversion of the loan into capital. Being an instrument used in the early stages of the project, a term of 1 to 2 years is usually set for the conversion.

Ceiling clauses in the convertible notes, or CAP clauses

This type of clause is of particular interest to investors, since, if the valuation of the company is very high, the capital borrowed will be diluted and converted into fewer shares than if the valuation were lower.

For this reason, the so-called ceiling or “CAP” clauses are usually introduced to determine that, once a specific valuation has been reached, it cannot be exceeded when converting the loan. They act as a kind of limit to the valuation of the company for the purposes of the convertible note.

Advantages of convertible notes

Convertible notes are a very useful instrument for startups to obtain financing due to their agility and simplicity.

First of all, it is a way to get capital quickly for a startup, since signing the contract will be enough, without any additional action being necessary. This agility is not only advantageous for the startup itself, but also investors are often interested in allowing the project to advance faster, which translates into a quick return on investment.

In addition, a convertible note allows for a subsequent valuation of the startup, in which case it is possible to set a maximum valuation amount (CAP) at which the money provided by the investor can be converted.

It is also a very attractive instrument as it offers the possibility of including discounts in favor of the investor on the price of the shares, motivating and rewarding the assumption of risk in carrying out the capital investment.

We must not forget that the simplicity of the convertible notes means that there will be no additional costs not initially considered for notary fees and registration in the Commercial Registry, which is especially interesting in the early stages of the project.

At LETSLAW we are experts in advising on the preparation of convertible notes to assist in the financing of Startups. Our professionals in the Corporate and M&A department will be able to advise you on everything you need for the drafting, review and negotiation of a convertible note.