Convertible notes are a popular method used by startup companies to raise capital for a new business. There are, however, different types of convertible notes, and it is important for new business owners to understand the pros and cons of each. It is also critical that business owners understand the long-term consequences of convertible notes on their future business operations and financing.
SAFE (a Simple Agreement for Future Equity) is a convertible note in which an investor converts his or her investment into equity in the company. With a SAFE agreement, the investment converts to equity at any future equity financing. There is no maturity date. Thus, the investor could convert the debt to equity the very next day if an applicable equity financing is completed. KISS is a different type of convertible equity that may or may not have a maturity date.
Equity or Debt
KISS (Keep It Simple Securities) are another form of convertible equity. While it is not technically a convertible note, it uses the same model to change a cash investment into equity in a new business. KISS notes follow one of two main formats: a debt version or an equity version. The debt version has an interest rate and a maturity date, while the equity version has neither. In the debt version, the investor may claim the right to convert his or her investment into equity after the specified date (usually eighteen months from the date the security is issued). KISS notes can also automatically convert to equity when the company raises $1 million in financing.
Interest and Caps
Like other investments, convertible notes usually accrue interest, but they are not paid back in cash because the principal is also not paid back in cash. Instead, the interest is realized as added equity in the company at the time of conversion. Interest is usually assessed at a fair market value but should not be lower than the Federal Reserve’s current prime rate to avoid other legal complications.
Convertible notes are usually issued at an early point in a company’s existence when valuation is difficult, if not impossible. Rather than negotiating a value with little data to support it, investors and startups will instead “cap” the present value of the company at an agreed-upon amount in the convertible note documents. The idea is that the value of the company will be greater by the time it secures Series A financing, which in turn allows investors to convert their equity into shares of a company that is worth more at that time.
Experienced California Business Lawyers for All Types of Financing
Convertible notes can be an effective tool for raising startup capital for a new business. Entrepreneurs must, however, understand these tools to use them effectively and ensure the continued success of their new businesses. The experienced California corporate lawyers at Structure Law Group are here to help you explore all options for raising startup capital and find the one that is best for your unique situation. Call (408) 441-7500 to schedule a consultation.