What Is a Convertible Note for Startups Fundraising?

If you’re exploring options to raise capital in the early stages of your startup, you’ve likely come across convertible notes. This financing instrument is widely used by startups and entrepreneurs to secure funds quickly without dealing with complex valuations or lengthy negotiation processes.

In this article, I’ll explain in simple terms what a convertible note is, how it works, and why I’ve used it in all my startups.

What Is a Convertible Note?

A convertible note is a type of loan that an investor gives to a startup, with the unique characteristic that instead of being repaid in cash, the loan is converted into equity in the company during a future funding round.

It’s a fast and flexible solution for startups that need initial capital while working to secure the rest of their funding round.

In short: the investor lends you money now, and that money is converted into ownership shares when you finalize the investment round at a notary.

How Does a Convertible Note Work?

While the specifics can vary depending on the contract, here are the key components of a convertible note:

1. Loan Amount: The amount of money the investor lends to the startup.
2. Interest Rate: Legally, a convertible note must include an interest rate. This interest is typically paid only if the investor decides not to convert the loan into equity, as they always have the option not to convert.
3. Discount: If an investor provides funding before you complete the round, their risk is higher. To compensate, convertible notes often include a discount of around 20% on the price per share.
4. Valuation Cap: This is the maximum valuation at which the loan will convert into equity. It protects the investor, ensuring they receive a reasonable share of the company if the valuation increases significantly. Sometimes, a minimum and maximum cap are used, or a fixed pre-money valuation is set (e.g., €2M pre-money).
5. Expiration and Conversion: Conversion occurs once all convertible note capital is secured, typically formalized at a notary. The conversion deadline is usually set at 1 year, but extensions can be signed if necessary.

Advantages of Convertible Notes

1. Simplicity and Speed: It’s a private contract between the investor and the startup.
2. Immediate Cash Flow: It provides initial capital to start operations, such as product development or marketing.
3. Cost Savings: It avoids unnecessary notary fees until the full round is finalized.

Tips for Using Convertible Notes

1. ENISA Loans: If you apply for an ENISA loan in Spain and it’s approved, you’ll need to convert the convertible notes into equity before receiving the funds.
2. Cash Management: Founders often spend convertible note funds on team growth, marketing, etc., and may run out of cash by the time the round closes. Plan carefully.
3. Unexpected Dilution: Without a proper equity waterfall analysis, you might face unexpected dilution. At Bolkana, we explain how to manage this effectively in this post.

If you’re looking to raise capital for your startup, at Bolkana, we’re here to guide you every step of the way. Apply to our program to simplify your fundraising and take your startup to the next level.

Lavin Manwani
CEO