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Convertible Note

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What is a Convertible Note? 

A convertible note is a type of short-term debt that converts into equity, typically in conjunction with a future financing round. Instead of repaying the loan in cash, the investor receives shares in the company.

How It Works:

  • Issuance: The company issues a convertible note to an investor.
  • Conversion Trigger: The note converts to equity during a future financing event, such as a Series A round.
  • Terms: Includes interest rate, maturity date, discount rate, and valuation cap.

Advantages: 

Convertible notes offer flexibility and simplicity, making them an attractive option for early-stage startups. They eliminate the need for immediate valuation, allowing companies to secure funds quickly. Additionally, they provide speed and efficiency, reducing the time and costs associated with traditional equity financing. Investors benefit from potential higher returns through discounts or valuation caps, enhancing the appeal of their investment.

Disadvantages: 

However, convertible notes come with uncertainties, particularly regarding ownership dilution, which remains unknown until the conversion event. Negotiating terms like discount rates and valuation caps can be complex, often requiring legal assistance. There is also the risk of conversion issues if future funding rounds do not occur as planned, potentially leading to unfavorable terms for either party.

Example: 

A notable example is Airbnb's use of convertible notes to raise $600 million in 2020. These notes were set to convert to equity at a 10% discount during a future equity financing round, demonstrating how convertible notes can provide immediate funding while deferring valuation negotiations.

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Related Terms

Adjusted EBITDA

Adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a financial metric used to assess a company's operational performance. It modifies the standard EBITDA by excluding non-recurring, irregular, or non-cash expenses to provide a more accurate reflection of ongoing profitability.

Angel Investors

Angel investors are affluent individuals who provide capital to startups or early-stage companies in exchange for equity ownership or convertible debt. These investors often offer not only financial support but also valuable business expertise and mentorship.

Anti-Dilution Provision

An anti-dilution provision is a clause in an investment agreement that protects an investor from dilution of their ownership percentage in the event that new shares are issued at a price lower than the investor originally paid. It is commonly included in venture capital and private equity agreements.

Bootstrapping

Bootstrapping in business refers to starting and growing a company using personal finances or the company’s operating revenues, rather than relying on external funding or venture capital. Entrepreneurs use their own resources and reinvest profits from initial sales to fund further growth, emphasizing financial independence and careful cash flow management.

Bridge Loan

A bridge loan is a short-term loan used to meet immediate financing needs while waiting for more permanent funding. It serves as a temporary solution to bridge the gap between the need for funds and the availability of long-term financing.

Cap Table

A Cap Table, or Capitalization Table, is a detailed spreadsheet or document that outlines the equity ownership, types of shares, and ownership percentages of a company. It includes information on founders, investors, and employees, as well as the dilution of shares over time through various funding rounds and option grants.

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