Startups are the future of the economy. With the increase in curiosity, many individuals are ready to create something big that is capable of solving and addressing the problem that hasn’t been touched yet. But, these startups, unfortunately, face multiple problems in the initial period, and funding is among the major ones.
Raising funds without the process of valuation is a big deal, and today we’ll be seeing the process of raising funds using convertible notes. If you’re a startup owner looking for ways to generate funds without getting into the process of valuation, convertible notes can be the best option for you. With this, let’s begin with this blog by understanding what are convertible notes.
What Are Convertible Notes?
A convertible note can be considered a short-term debt where the principal and interest amount can be converted into an equity investment. This allows the owner of a startup as well as the investor, to skip the process of valuation for immediate funding and later convert the debt amount into equity shares.
There are multiple terms that are pre-decided in the case of convertible notes. Like, maturity date, which means the time at which the company needs to pay back to investors. Another term is interest rate, which is an important term while performing any investment transaction.
The convertible note is a win-win option for both parties. The owner gets the funding without worrying about valuation, and the investor gets the option of converting this transaction from debt to equity.
Let us now see how raising funds using convertible notes works.
Raising Funds Using Convertible Notes
To raise funds with the mode of convertible notes, startups usually issue a note and distribute it among possible investors like friends, business connections, family members, and more. If any of the investors are interested, they can review the terms and conditions and can continue with the investment process.
Upon interest, various terms, like maturity date, interest, price, discount, etc., are discussed and negotiated between both parties if required. Once the investor is finalized and the investment proceeds, the startup owner uses the funds for multiple operations of the business.
Long after, when the first round of investment is raised via the equity method, these convertible note holders are given the option to get paid back in cash or own shares in the business. This is how raising funds with convertible notes works. Raising funds through this method usually requires expert supervision and advice so that both parties are winning from the deal.
You might be wondering what are some of the benefits of raising funds through convertible notes. Let’s have a quick look into this too.
Pros of Utilizing Convertible Notes
Using convertible notes to raise investments benefits not only the business owner but also the investor. Let’s see what those benefits are:
Remember how rigid traditional loans are regarding the repayment element. But unlike the old loan system, convertible notes are flexible and give the benefit of converting the debt to equity to the investor. Even the business owner need not worry about payment.
Convertible notes don’t need huge documentation except for some things like convertible note agreements. This element ends up saving huge time and money resources for the owner, ultimately helping in raising funds quicker.
It is difficult to dilute the ownership of such a new business. At the later stage, when the company would be at a larger scale, diluting ownership with a small percentage won’t be of much an issue as compared to the early stage. This is the primary benefit of convertible notes for the business owner.
Well, the grass is not fully green in any garden. Along with so many benefits, startups should consider and get legal advice on whether to go for convertible notes.
Are Convertible Notes the Right Strategy?
Seeing all these benefits might seem perfect, but convertible notes have their fair share of risks too. However, it might be the best option to avoid the valuation process and gain funds. But, investors have every right to ask for repayment if the startup fails to raise equity shares in the market.
Also, the minimum amount for issuing a convertible startup is 25 lakhs which, of course, is not suitable for small-scale startups. Lastly, the startup owner should be fully ready to dilute the equity in the future before raising convertible notes.
Similar to this limit, there are other concerns that a startup owner might have, like filing convertible notes or how to report them. Let’s quickly look into that before concluding this blog.
Reporting & Filing Requirements
The following are the minimum requirements for issuing and reporting convertible notes:
Any startup can issue a convertible note by filing the MGT-14 form with the ROC within 30 days.
Also, if an Indian startup owner raises convertible notes for an individual outside India, the owner must fill out form CN within 30 days.
It is also essential to file convertible notes correctly in the financial books. The need for clarification on considering convertible notes as future equity or current debt is in the startup owner’s mind. However, convertible notes have characteristics similar to debt, like principle amount, interest amount, maturity date, etc. Also, there’s no guarantee of conversion of a convertible loan to an equity share in the future. Therefore, convertible notes are reported in financial statements as unsecured loans.
Like any other way of raising investment, convertible notes come with pros and cons for owners and investors. It is advisable to get expert advice on the situation before jumping to any conclusion. In conclusion, it’s time to wrap this blog up.
In the blog, we saw what is a convertible note in venture capital. And it is safe to say that this is one of the easiest methods to skip the valuation process and raise funds. But, it is also advisable to know about all the future impacts that a convertible note agreement might have on you or your business. As the famous saying goes, it is better to be safe than sorry, especially in terms of investment.
Lastly, we hope the blog helped you get your doubts cleared in case you had regarding convertible notes. If you’re a business owner ready for a seed funding round and are a valuation professional, My Valuation is your best option.
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