written by khatabook | November 18, 2022

Everything You Ever Wanted To Know About Convertible Note | Pros & Cons

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Table of Content


A convertible note is a type of short-term debt that converts into equity. The equity can be in the form of common stock or preferred stock. Convertible notes are often used by startups to raise seed capital. The main advantage of a convertible note is that it allows startups to delay setting a valuation for their company. Convertible notes have a few key terms that must be negotiated between the startup and the investor. These terms include the conversion price, interest rate, and maturity date. The conversion price is the price per share that the investor will receive when the convertible note converts to equity. The interest rate is the percentage of the principal that will be paid to the investor as interest. The maturity date is the date when the convertible note must be repaid in full.  

Overall, a convertible note can be a helpful tool for startups to raise seed capital. It gives them the ability to delay setting a valuation for the company and offer a reasonable rate of return to the investors. 

Did you know?

Convertible notes are only ideal for early-stage startups that are in high-growth phases. 

What is Convertible Note?

A convertible note is a type of short-term debt that converts into equity after a predetermined time period. The convertible note contains a conversion price that determines how much equity the noteholder will receive when it converts. The most common type of convertible note is the convertible promissory note, which includes a conversion feature. 

Convertible notes are often used by startups to raise seed capital. The main advantage of a convertible note is that it allows startups to raise capital without giving up equity in the company. This can be beneficial for startups that are not yet ready to value their company or that want to delay giving up equity for as long as possible. 

Convertible notes also allow investors to invest in a company before it goes public or is acquired. Convertible notes are relatively straightforward to understand and execute. Convertible notes can also be structured in a variety of ways to meet the needs of both the company and the investors.  

Also Read: What are Accounting Principles and Accounting Concepts - Here's a Detailed Overview

Why Would a Company Issue a Convertible Note? 

There are a few reasons why a company might issue a convertible note.  

  • One reason is that it allows the company to raise money without giving up equity in the company. 
  • This can be beneficial for the company if it is not yet ready to give up equity or if it does not want to dilute the equity that existing shareholders own.  
  • Another reason is that it can be easier to raise money through a convertible note than through other methods, such as equity financing. 
  • It is because investors are often more willing to invest in a company that has the potential to convert their investment into equity later.  
  • Finally, issuing a convertible note can help a company to delay the decision of how to value the company. 
  • This can be helpful if the company is not yet ready to set a valuation or if it wants to wait to see how the business develops before setting a valuation. 

Requirements for Issue of Convertible Note 

Only "Startup Companies" approved by the Ministry of Commerce and Industry's Department of Industrial Policy and Promotion may issue convertible notes (DIPP).

A convertible note is a document that documents the receipt of money initially as debt that the bearer may choose to repay. However, to issue a convertible note, the following requirements must be considered:

  • A single part of the investment in a convertible note must be at least ₹25 lakhs. 
  • Convertible Notes have two options: they can be repaid or converted into a specified number of equity shares of a starting firm. 
  • The convertible note must be repaid or converted within five years of the day it was issued. 
  • The instrument outlines the terms and conditions of the convertible note that have been agreed upon. 
  • Form CN filing requirements must be sent to (RBI) 

Also Read: What are Accounting Standards - List of Accounting Standards in Detail

Procedure for Issue of Convertible Note 

A convertible note is a debt instrument that can be converted into equity. This type of financing is often used by startups that are not yet ready to issue equity. The benefits of convertible notes include the ability to delay the valuation of the company and the flexibility to convert the debt into equity later.  

The first step in issuing a convertible note is to determine the amount of money that will be raised. The company will then need to find investors who are willing to provide the funding. Once the funding has been secured, the company will need to draft a convertible note agreement. This agreement will outline the terms of the loan, including the interest rate, the maturity date, and the conversion terms. The next step is to negotiate the terms of the convertible note with the investors. Once the terms have been agreed upon, the company will need to issue the convertible note. The final step is to file the convertible note with the SEC (Securities and Exchange Commission ). 

Pros of a Convertible Note  

  • One advantage of a convertible note is that it allows a company to raise capital without having to value the company at the time of investment.
  • This can be beneficial if the company is not yet ready to undergo a full valuation, or if the company is not yet generating enough revenue to justify a higher valuation. 
  • Another advantage of a convertible note is that it can help to align the interests of the investors and the company. 
  • This is because the investors are effectively betting on the success of the company and will only receive a return on their investment if the company is successful. 
  • And it aligns the interests of the investors and the company, as both parties are motivated to see the company succeed. 

Cons of a Convertible Note

  • A disadvantage of a convertible note is that it can be difficult to negotiate the terms of the note. This is because the terms of the note will be based on the valuation of the company, which can be difficult to determine. 
  • In addition, the terms of the note can be complex, and it can be difficult to explain the terms to potential investors. 
  • Another disadvantage of a convertible note is that it can dilute the ownership of the company. 
  • This is because the investors will own a percentage of the company, and the founders will own a smaller percentage. 
  • And it can be a problem if the founders want to maintain control of the company. 

Also Read: What is an Accounting Voucher? Know Meaning and Types of Accounting Vouchers.

Conclusion 

A convertible note is a debt instrument that can be converted into equity later. This makes it an attractive financing option for startups that are seeking seed funding or early-stage financing, as it allows them to raise capital without giving up equity in the company. While a convertible note can be a helpful tool for startups, it is important to remember that it is still a debt instrument. This means that the company will be responsible for paying back the principal amount, plus interest. For this reason, it is important to carefully consider the terms of the loan and to make sure that the company will be able to make the payments when they come due. 

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FAQs

Q: What are the risks of a convertible note?

Ans:

The main risk of a convertible note is that the borrower may not be able to raise enough money to repay the loan when it comes due. If the company's value has not increased as expected, the lender may not be willing to convert the loan into equity, and the borrower may be forced to sell assets or declare bankruptcy. Another risk is that the terms of the conversion price may be unfavourable to the borrower if the company's value has increased more than expected.

Q: What are the benefits of a convertible note?

Ans:

The main benefit of a convertible note is that it allows the borrower to delay the decision on what type of equity to issue until a later date when the company's value is more certain. Convertible notes also typically have lower interest rates than traditional loans and may be easier to obtain from investors. 

Q: What are the terms of a typical convertible note?

Ans:

The terms of a convertible note will vary depending on the specific agreement between the borrower and lender, but there are some common features. Convertible notes typically have a fixed interest rate, a maturity date, and a conversion price. The conversion price is the price per share of equity that the borrower will issue to the lender when the note is converted. The maturity date is the date on which the loan must be repaid in full, and the interest rate is the percentage of the loan that must be paid as interest.

Q: What is the meaning of a convertible note?

Ans:

A convertible note is a debt instrument that can be converted into equity at a later date, usually at the discretion of the lender. Convertible notes typically have lower interest rates than traditional loans and may be easier to obtain from investors.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.