Traditionally, convertible notes (or convertible promissory notes) have been the primary means of raising seed capital for startups. However, the trend amongst tech startups has been to turn toward safes and other alternative approaches to securing this financing.
That said, understanding convertible notes is key to deciding what is best for your startup.
Promissory notes are a promise of payment to the note’s holder at a specific date in the future — referred to as the maturity date.Convertible notes are those that promise to convert into stock at specific, predetermined events in the lifecycle of the startup. Upon the sale of convertible notes, the corporation generally enters into an agreement to buy back the notes with interest should the notes not convert to stock by the maturity date.
Although there is this built-in protection for noteholders, both the noteholder and the corporation generally enter into this agreement with the intention of having the stock convert into preferred stock issued at the company’s subsequent equity financing.
Such notes also often convert into shares of the corporation’s stock if the company is acquired or if it goes public through an Initial Public Offering process. To this end, startups generally institute valuation caps or discounts which essentially limit the number of shares a note will convert to in order to better manage the potential equity that comes with startups.
Although they are still quite popular to use, promissory notes can be a bit cumbersome for startups in that they are essentially a stock option with the added layer of interest to be repaid in the event that a note doesn’t convert by its projected date for whatever reason. This is largely a product of the origin of promissory notes — they were initially intended for the purpose of bridge loans from venture capitalists to startups. Their usage expanded because of the relatively simple paperwork and negotiation requirements.
Because of this, there are new means of achieving seed financing being explored in various startup ecosystems across the country — particularly in the Silicon Valley.