🧒 Explain Like I'm 5
Think of a convertible note like giving your friend gas money because they promise to buy a car soon. Right now, they can't give you a ride because they don't own a car yet. But once they do, you'll get special privileges, like picking the music or getting extra rides. In the startup world, a convertible note is when an investor gives money to a startup with the promise that this money will turn into a piece of the company later, once the startup raises more funds and is ready to sell shares. This is important because it helps startups get the money they need to grow without immediately deciding how much the company is worth, which can be tricky when they're just starting out. For someone starting a business, knowing how convertible notes work is important because they offer a quick and flexible way to get initial funding without giving up ownership right away.
📚 Technical Definition
Definition
A convertible note is a form of short-term debt that converts into equity, typically during a future financing round. This approach allows startups to delay their valuation until they have more data to support it, usually at a later stage.Key Characteristics
- No Immediate Valuation: The valuation is postponed until a future financing event, simplifying early-stage negotiations.
- Interest Rate: These notes accrue interest, which often converts into additional shares upon conversion.
- Discount Rate: Investors may receive a discount on the future share price, compensating for their early investment risk.
- Maturity Date: If conversion doesn’t happen by this date, specific repayment or conversion terms are activated.
- Cap: A valuation cap sets the maximum price at which the note will convert, protecting investors if the company's value increases significantly.
Comparison
| Feature | Convertible Note | Equity Financing |
|---|
| Valuation | Deferred | Immediate |
|---|---|---|
| Complexity | Simpler | More Complex |
| Investor Return | Equity on Conversion | Direct Equity |
| Risk Mitigation | Discount, Cap | None |
Real-World Example
Dropbox utilized convertible notes in its early days to secure funding before having a substantial track record. This strategy allowed them to delay valuation discussions until they gained more market traction, benefiting both the company and its early investors.Common Misconceptions
- Instant Equity: Conversion into equity does not happen immediately; it's contingent on future funding rounds.
- Guaranteed Conversion: Conversion is not guaranteed and depends on the occurrence of future financing events.
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