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How does a convertible note work?

A convertible note is an investment structure that allows a company to take on funding in exchange for equity at a later date.  At the time of the investment, the funds are allocated as debt on the company's balance sheet.  However, at some date in the future, the intention is to convert those funds (+ any accrued interest) to equity based on a specific event occurring.  Usually that event is defined as a 1) qualified equity financing or 2) a date sometime in the future at which point the debt will convert to equity at a defined valuation (or valuation formula).  A discount is typically included in a convertible note that provides investors equity in a qualified financing at a cheaper per unit price than what is offered to new investors. Finally, a maturity date is often included at which point debt plus interest is due and payable to investors if the conversion to equity has not occurred.  

A convertible note can be a good tool for a company to raise funds to help bridge to a larger equity offering.  For companies that are early with respect to customer and revenue traction it can be difficult to set terms of an equity offering, specifically the valuation of the business.  A convertible note removes those topics from the conversation, providing a simpler transaction structure to close a smaller amount of funding. The company should then be able to more quickly close and deploy the capital to make progress with the business. 

When the company has more meaningful traction on revenue and customer growth, there will be a stronger basis from which to set equity terms (the qualified equity financing).  This equity financing ideally takes place within 12-18 months of the convertible note date. At that time, the note holders can convert their investment into equity at the terms defined in the new financing. The conversion happens at a discount (defined in the note) to the price of the equity to compensate note holders for the earlier investment.  Important conversion mechanics need to be detailed in the convertible note so both company and investors understand how the note holders will receive their equity.  

The intent of a convertible note is to provide the company a simple, short term instrument to close funding that will help the business make progress from which to base a larger, priced equity offering in the future. In exchange, investors are provided a discount to the future equity to compensate for their earlier investment. 

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