Convertible Notes are financial instruments used by investors to provide seed funding to early stage startups.

There the above line is a simple one-line definition of convertible notes. 

But of course, you are here for more than just that, aren’t you?

Early stage startups are not perfectly established entities so determining a valuation is not an easy task. This is why funding here is a tedious process. 

From a verbal agreement to actual money in the bank, it can take about 6 months. 

Most companies do not have 6 months to wait, this is where “Convertible Notes” come into the picture. 

A convertible note is like a debt which the investor lends to the founder. 

The difference here is as collateral, the investor gets the company’s stock later in the future.

Definition

Imagine a budding startup. Let’s say that its sector is mental – health.

Through Instagram, this startup is trying to heavily market itself through informative posts, affordable therapy packages, and webinars.

But all of this is being done by a very small team. Moreover, there is a reliance on organic reach over paid advertising due to a lack of budget.

Worst of all – there is no physical infrastructure yet where the client can come and receive therapy.

Considering this is a mental health sector, complete digitization of therapy really sets back the client base.

The idea, however, is promising.

The startup then approaches some angel investors from Hong Kong for funding.

They like the idea but are not sure about the value of the startup or the success of the business model.

They decide to fund the startup nonetheless but in the form of a debt which will be converted to equity in the company during the next round of financing.

This means that the startup founders have now received a loan to hire a good team, rent a room for therapy, and budget the marketing. 

They will need to pay back both principal and interest at the next round of financing. But, for both founders and investors, it’s more preferable to go for the option of equity.

The investors will be allowed to buy shares of the company’s stock (maybe at a discounted price) at the subsequent financing round. 

Convertible notes, hence, are short-term debt instruments that can be converted into equity in conjunction with the startup’s subsequent financing round. 

Founders are able to secure heavy funding for the execution of their startup’s business model while investors are safely able to capitalize on a high-risk venture.

Key Terms 

1. Valuation Cap

The crux of the matter is that funding an early-stage venture is highly risky. 

Consequently, convertible notes come with certain investor-friendly clauses to reward investors for the risk they seem to be taking. A valuation cap is one of them.

This cap sets up a limit on the value of the startup.

Why?

Because the value of the startup may increase exponentially in the next financing round. This may make the share price more expensive for the convertible note investor.

Here, the valuation cap will allow the investor to buy shares at a lower price on the basis of the pre-decided valuation at the time of the issuance of the note.

For example, the valuation cap is negotiated to be $1.5 million at the time of issuance of the note. Later, the company’s value increases to $2 million by the next financing round. Despite this, the note-holding investor can still purchase shares on the basis of a $1.5 million cap.

This provision protects the investor against dilution (losing ownership) in the face of newer investors establishing their stake in the growing startup.

On the other hand, if the later valuation is actually less than the cap, say $1 million. 

In this case, the investors will own proportionately more stake at $1 million which equals their valuation at $1.5 million.

2. Discount Cap

A discount cap is also a mechanism to reward the note-holding investors by allowing them to purchase the shares of the company at a reduced price as compared to the next investors.

For example, if the note-holding investor funds the startup with $500,000 and is granted the clause which allows a 20% discount in buying shares at the later financing round, the investor will be able to purchase shares at $0.80 rather than $1. The new investor, on the other hand, will be able to buy shares at $1.

Discounts typically range from 7% – 35%.

They offer an attractive deal for the investor to capitalize on the startup and own high equity later. 

The founder, however, should use such clauses with discretion as there is always a risk of dilution (losing more and more ownership to investors) later.

3. Maturity Date

Lest we forget, convertible notes are debt instruments. 

This means that they carry an aspect of a looming due date at which the debt is ought to be converted to equity as a part of the agreement. 

There are multiple events that can occur as this period comes to an end.

Either the startup will successfully raise good funding in the next financing round and the note-holder will happily go home with equity, or this will not happen.

In case the startup is unable to raise capital in another funding round, then any 1 out of these 3 scenarios occur – 

1 – The investor can extend the maturity date 

2 – The startup can be obligated to repay the debt in full, inclusive of both principal and interest rate. Bankruptcy is declared if the startup is incapable of executing repayment. 

3 – Through negotiation, the note can be converted into equity at a later date but with a different valuation. 

4. Interest Rate 

Convertible notes accrue interest from the time the note is issued till the end of the maturity period.

The startup is required to pay simple interest on the amount of the loan. Historically, the annual range has been 5% – 7%.

This interest, however, is not paid in cash on a periodic basis. It is accumulated through the entire time of the maturity period and is added to the loan.

It is this total amount that is converted into shares at the subsequent financing round

Prerequisites Before Issuing a Convertible Note

1. Only a ‘startup’, or an early-stage company, can issue a convertible note.This means that the startup should be a private company incorporated under the provisions of the Companies Act, 2013, and recognized as a startup under the Department for Promotion of Industry and Internal Trade (DPIIT).

2. The funding amount along with the terms and conditions should be discussed at the time of note issuance. 
3. The startup’s worth – or valuation before the next financing round – should be estimated only through RBI’s guidelines.

Pros and Cons 

Implications in the Indian Startup Ecosystem 

“The sheer diversity of investors that are now actively investing in India – by geography (including North America, Asia, and the Middle East) as well as sector preferences – provides scope for optimism that the momentum will be maintained,” 

• Arun Natarajan, Founder, Venture Intelligence

Before 2017, the Reserve Bank of India (RBI) did not allow foreign investors to provide loans to the Indian startup ecosystem.

After 2017, a change in policy allowed Indian startups to approach foreign investors with their promising ideas and raise funding through issuing convertible notes.

This policy change was done to attract investors from abroad and to boost an aggressive expansion of domestic startups.

In fact, ever since this new policy announcement, India has become an attractive investment destination to inject fundings from Silicon Valley, Hong Kong, Singapore, UAE, and more. 

The Indian government also seems to be joining this race of funding through convertible notes.

For instance, the Startup India Seed Fund (this is a governmental scheme) supported 3,600 new entrepreneurs of DPIIT – registered startups through 300 incubators. It granted INR 50 Lakhs via convertible notes for marketing of the product in April 2021 (source). 

What’s more, is that the pandemic situation has encouraged a lot of founders and investors to use convertible notes for quick funding. 

For example, MakeMyTrip managed to rope in investors from abroad and raise $200 Million in debt through convertible notes despite their market being affected by a decline in travel due to the pandemic. (source). 

This just goes to show that convertible notes are making it possible for rapidly growing Indian startups to rake in heavy funding from foreign and domestic investors. Sectors include EdTech, HealthTech, FinTech, FoodTech, e-commerce, and more. 

Conclusion

The volatile expansion of startups has not stopped despite the havoc caused by the recent pandemic. 

Convertible notes are offering both investors and founders a gateway to launch and grow promising ideas. 

Investors get to diversify their portfolios by injecting capital in these alternative, high-risk ventures in hopes of exponential returns. 

Domestic startups, hence, are seeing a massive capital flow of funding, especially in 2021. Convertible notes are making it easier for startups to expand their business model in an exponential manner.