Convertible notes are emerging as a favorite mode of investment in startups for both the investor and the founders. Let's find out why.
What are convertible notes?
Convertible Notes are a form of loan from investors which can be converted into Equity Shares later based on future business valuation.
When are they used?
Convertible Notes are primarily used by early-stage startups to raise capital in their seed round of funding.
Salient features of Convertible Notes
Maturity Date- The convertible note will contain a due date as to when the company needs to repay it.
Discount rate- It is the rate of discount on the price per share compared to the price paid by other investors in the subsequent funding rounds.
Valuation Cap- It is the maximum valuation of the company at which the convertible notes will convert into equity in the future.
Interest Rate- It is the rate of interest charged for the loan which is accrued and added to the principal amount which will later result in an increased number of shares in the event of conversion.
Conditions for issue of convertible notes in India
Minimum investment amount to be invested in a single tranche - INR 25 lakhs
The startup issuing convertible notes should be registered under the Startup India scheme.
Convertible notes can be issued for a maximum tenure of upto 5 years only
Other Aspects
At the time of the issue of convertible notes, the valuation of the startup is not required and is only needed at the later stages of funding when there are more defined data points to aid in the valuation of the company. The startup can thus enjoy the capital for building the business without any upfront dilution in the equity stake of the company.
It is to be noted that an investor may choose not to exercise his/her right to convert the notes into equity at future funding rounds which will entail the company repaying the debt and accrued interest potentially pushing weaker companies into bankruptcy.
Conclusion
The issue of convertible notes is a fairly simple and flexible option to fund a startup, especially during its initial stages from angel investors. It is also the route for availing unsecured loans by Private Limited companies from persons other than its directors. However, the company needs to exercise due caution since it is a risky option because the investor has an option not to exercise his rights which will in turn affect the liquidity and solvency of the company.
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