Are convertible notes the right way to fund your startup?

If an early-stage startup is ready to raise money but its valuation hasn’t been established yet, a convertible note can serve as a good fundraising option.

A convertible note is a debt instrument that typically converts into equity at a later date. Investors who invest in a note are effectively loaning money to the startup, but instead of getting their investment back as dollars with interest, they get it back in the form of equity once a valuation is assigned at a later fundraising round.

This approach has a number of advantages for both the company and investors. Convertible notes allow companies to delay being valued until an equity funding round, extending the time they have to build a product and flesh it out. And for investors, while riskier than the traditional funding route, convertible notes give them an opportunity to get more equity for their money than if they wait until Series A.

How to tell if convertible notes are a good fit for your startup

One advantage to convertible notes that founders shouldn’t overlook is that they typically don’t come with any control or board seats.

Convertible notes work best for early-stage companies, especially pre-revenue startups. That could mean a company that has a solid proof of concept — a product that’s proven to work on the current scale or a medical device in the early stages of applying for FDA approval.

In both cases, the companies are building their value, and the dollars they raise with a convertible note help them scale. The end result is that when they’re ready for an equity financing round, they’re already at a higher pre-money valuation than they would be otherwise.

When funding a company with a convertible note, investors look for massive upside potential. The best-case scenario is when the company ends up having a substantially higher-than-anticipated valuation by the time it gets to Series A.

Convertible notes typically include a valuation cap so that early investors don’t lose out if the company’s value skyrockets before a Series A. When the note converts, investors get more equity at the price of the valuation cap, and they share the benefits of the company’s increased value.

What kind of investors use convertible notes?