Source: Businessweek, Jan 2011
Convertible notes (known as converts in the investing community) are loans that turn into stock in the event of an acquisition or significant funding event. Converts are typically used for companies that need quick cash, are hard to value early on, or require a small round of financing (usually no more than $500,000). Although the valuation of the startup is deferred until the triggering event, investors in converts usually get slightly better terms than the ones offered to subsequent investors in a priced round. Widely regarded as entrepreneur-friendly structures, converts don’t place an immediate interest burden on cash flow; coupon payments to note holders are accrued, instead of paid out in intervals.
The legal fees for a capital infusion of merely a few hundred thousand dollars were likely to cost 15 percent to 30 percent of the entire raise, making a traditional priced round less attractive. Because converts are debt, they are negotiated with less back and forth on governance. By postponing discussions of valuations, board seats, and oversight clauses, the funding process goes faster, which also helps keep legal fees low. It cost Little Passports $10,000 in legal fees to structure its $175,000 round as a convert, vs. $25,000 to $50,000 for documentation associated with a priced round of preferred shares. For founders raising less than $500,000 at a time, the savings from converts are noteworthy.