Convertible Notes: A Form of Early-Stage Financing

Abstract

Convertible notes are often used to raise early-stage financing for start-up companies, frequently due to their advantages related to delayed valuation, greater speed, and lower cost of completion compared to venture capital financing. As a result, there has been a large increase in the number of early-stage companies raising capital through convertible notes over the past decade. Investors have made this form of financing more available, believing that small amounts of money can significantly advance the development of young companies. Entrepreneurs often find that convertible notes are easier to raise than a first round of venture capital. The ease of convertible note financing, however, sometimes belies the hidden risks and costs associated with its use. This technical note discusses the most frequently used terms and arrangements of early-stage convertible notes, the estimation of the noteholder's equity ownership from delayed valuation, and the costs and risks of this form of financing to both entrepreneurs and investors. The case MedMetric, LLC: Seed-Round Convertible Note Financing (UVA-F-1924) can be assigned with the note as an application of this form of financing. Excerpt UVA-F-1925 Dec. 13, 2019 Convertible Notes: A Form of Early-Stage Financing Over the decade leading up to 2019, there has been a large increase in the number of early-stage companies raising capital through convertible notes. Investors have made this form of financing more available in the belief that small amounts of money can significantly advance the development of young companies. Entrepreneurs often find that convertible notes (or notes) are easier to raise than a first round of venture capital (VC) and facilitate the participation of friends and family in their ventures. The ease of the financing, however, sometimes belies the hidden risks and costs associated with its use. This note discusses the most frequently used terms and arrangements of early-stage convertible notes and the costs and risks of this form of financing to both entrepreneurs and investors. What Is a Convertible Note? A convertible note is a debt instrument that converts into equity in connection with a future financing. A convertible note used to fund an early-stage or round financing typically converts into shares of preferred stock upon the closing of a subsequent VC-round financing (e.g., Series A or B). The conversion is often accompanied by terms favorable to investors, such as a conversion discount (discount) or conversion valuation cap (cap). Because a convertible note is a debt instrument, its use in a seed round does not confer a value on a company, and therefore is considered an unpriced round. . . .