If you are considering raising money for your startup, there are two main ways you can do it: either by issuing shares (equity) in exchange for money, or by using convertible notes. In this guide we explain how each approach works and the pros & cons of the two methods.
Other resources in our series on convertible notes:
- KISS term sheet template (PDF & Word versions)
- KISS convertible note template (PDF & Word versions)
- SAFE convertible note template (PDF & Word versions)
what is a convertible note?
In simple terms, a convertible note is a loan that converts to shares when you do your next fundraising round – a qualifying capital raise. In other words, investors will lend money to a startup, and then rather than being repaid their money with interest, the investors will be issued shares in the startup’s next capital raising round. Originally used more for bridging rounds, where money was provided to a startup to cover costs until its the next funding round, convertible notes are now very common in seed rounds.
There are two key features of a convertible note. One is that a convertible note will usually convert at a discounted price to the next round price. In other words, founders are trying to incentivise investors by saying, “if you invest in us today [when we’re a riskier bet], we’ll give you % off when it comes time for our Series A round”.
The second key feature is its valuation cap, which protects investors by putting a ceiling on the conversion price of the note and lets the investors share in any significant increase in valuation (that might have come as a result of their investment of money and resources).
types of convertible note
Under the KISS convertible note, the note is repayable on the maturity date (typically 18-24 months from the date of the convertible note) if it has not already converted to shares. The investor can also choose to be repaid the investment amount on a liquidity event.
A SAFE note, on the other hand, is not repayable at the end of a fixed period, and the company must only repay the note if an insolvency event occurs, or if the investor chooses to be repaid on a liquidity event rather than convert their note. A SAFE is essentially a quasi-equity instrument, whereas a KISS is quasi-debt, because there is a contingent repayment obligation.
The KISS and the SAFE notes also differ in the ways that they can convert.
A KISS note converts:
- automatically when the company raises its next round (the qualifying capital raise);
- at the investor’s election when a liquidity event occurs (like the sale of the company); or
- at the investor’s election at the maturity date.
On the other hand, a SAFE note converts automatically when the company raises a qualifying capital raise, or if the investor so chooses on a liquidity event. The investor cannot force conversion after a fixed period.
There are also different types of SAFE notes, namely the pre-money SAFE and the newer post-money SAFE recently developed by Y Combinator. The difference between these is a substantial topic in and of itself – we recommend checking out some of the blog articles that others have written about it, like this one.
what is an equity investment?
Unlike a convertible note, under an equity investment, the investor receives shares in the company at the time of their investment. Where the investor is a VC or part of an angel group, those shares will typically be preference shares.
pros and cons: benefits of convertible notes
From a founder’s perspective, the biggest benefit of convertible notes over an equity financing is speed. The note is generally a single document with simpler terms to negotiate, and without lots of conditions and warranties.
In addition, the KISS and most other convertible notes are designed to be executed by individual investors, so it is possible to receive funds without closing with all investors simultaneously – a rolling close.
Here are some other benefits to using convertible notes:
- they postpone the difficult discussion about the company’s valuation. It is hard to value startups early on. Deferring the valuation until a larger equity round is raised is one way to address this (this doesn’t apply if you are using a post-money SAFE).
- they have a lower cost to execute. Convertible notes are simple and flexible. It involves a single document, whereas even small equity investments often involve a subscription agreement, shareholders’ agreement and a new constitution.
- there are fewer warranties. Subscription agreements often include multiple warranties which are inappropriate for an early stage startup. A convertible note generally includes only a handful of very focused warranties.
- they concede much less control. Noteholders typically receive little (if any) control over the company, e.g. no veto or director appointment rights. This works well with the need for startups to pivot and to raise the next round of funding without investor interference
- less administrative burden. The fewer shareholders you have, the fewer people you need to deal with when obtaining shareholder approvals and agreements for your next round, and in the operation of your company.
pros and cons: disadvantages of convertible notes
However, there are some downsides to convertible notes from a founder’s point of view:
- KISS convertible notes are debt. When you receive the money, the clock starts running towards repayment on the maturity date. If you have not completed a qualifying capital raise by that date, the debt needs to be repaid. While it is uncommon for investors to enforce that right and force the winding up of the company if the debt cannot be repaid, you may have to renegotiate some form of refinancing with note holders at which point you will be seriously on the back foot. However, this does not apply to SAFE notes which are quasi-equity, and do not have a repayment obligation.
- preference shares generally issued on conversion. Most convertible notes convert into the class of shares issued to the investors on the next round of financing. This usually means preference shares. As a result, convertible note investors have the double protection of both a price discount on conversion, plus the liquidation preference negotiated by the subsequent investors
- detached investors. Convertible notes often don’t include investor information rights or rights for investors to participate in later financings. This means convertible note investors are not as involved in the business as they might be if they held equity. Startups need all the help they can get, so make sure that your note holders are real supporters of the business and can potentially help bring in the next round of funding
Notes remain a very effective tool due to how quickly deals convertible note deals can be closed – we have seen convertible note financing rounds closed in a few days. For startups looking to raise money fast and get on with growing the business, this speed remains a key factor.
New to Kindrik Partners? View our other resources on capital raising.