What is a Convertible Note in England?

As the founder of a small or medium-sized business or startup, you may look at ways to finance your company’s growth. If you are running an early-stage company, having startup capital available is essential to achieving your short-term goals. Using a convertible note is an alternative to equity investment and can be beneficial for your business. This article will explain key ideas about convertible notes and how you might issue convertible notes to your advantage. 

What is a Convertible Note?

Generally, a note is a debt instrument. It is essentially a loan from an investor to your company. 

The investor gives you money, and in return, you agree to pay back the ‘principal’ amount at a set time. This is called the maturity date. You also give the investor interest, usually called ‘coupon’ payments. The principal is the amount you are borrowing as part of your agreement to issue the bond. 

A convertible note is slightly different. A convertible note is still like a loan, but it will automatically change from a note to a share. How this happens depends on the terms of the convertible note your company issues. 

Convertible Notes for Seed Investors

Seed investors are investors who are putting equity into early-stage companies. In seed funding, a convertible note is where the debt converts into preferred stock at a later date. An alternative option is where the debt converts into an obligation from the issuer to pay the principal amount. The period in which the notes convert into shares is usually at the end of a financing period. 

Typically, the share is preferred stock, meaning that the shareholders have priority in payments to common stockholders. Therefore, using a preferred stock method can help incentivise those investors and gain confidence in getting a return on their money. 

Why Not Issue Preferred Stock in the First Place?

You may wonder why you would go through the process of having a note convert into equity rather than just giving the equity outright. 

One key advantage is that by raising money through debt instruments, you do not have to calculate the company’s valuation until the end of the first equity round. At the end of the financing period, it will be much easier to value your startup. This will further grow shareholder confidence. Also, since there is no valuation, you will not have to deal with issues arising from tax, share dilution, and pricing options. 

Another key advantage of issuing convertible notes is its speed. Your company can make a convertible note offering with relatively low costs. Likewise, it is a swift process because all you will need is a short promissory note given to your prospective convertible noteholders. In contrast, issuing preferred stock on its own can take weeks and will cost you much more in legal fees. 

Additionally, because the investors are not holders of shares or equity, they will not have any of the rights of shareholders. This means they cannot make demands through board seats and veto rights, which they would typically have concerning certain corporate actions. 

Finally, because you are the issuer of the note, you will be able to set the price for giving the note to investors. This can avoid problems where investors wait to see whether other investors will invest before giving you equity themselves. 

Key Takeaways

Using convertible notes is a good way of raising money for your early-stage startup. It can help you keep flexibility when running your business while giving you a quick and cost-efficient way of raising money through investors. Convertible notes are a great way of raising money if your business is in its very early stages before you have a comprehensive company valuation. 

Alongside this, using convertible notes means that you can have equity investors at a later date in your company’s growth. This gives you more control over corporate decisions while still having debt raised without paying high-interest rates or worrying about making your principal payments at the note’s maturity date. 

If you need help understanding your capital raising options, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.

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