convertible promissory note- raising fund by startups

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Convertible Promissory Note-Raising Fund by Startups


Convertible Promissory Note

Today, we are in the golden age of startups, where people areready to take risks for their dreams and passion. It takes more thanjust a great idea to run a successful business. Entrepreneurs andexisting business owners need capital to pursue their dreams.

New business ventures often have difficulty obtaining capital(whether for starting up, or for expanding operations). Todayduring economic downturns where standards for commercialinvestment are becoming water tight, a number of investors oftenseek non-traditional investment opportunities to enhance theirportfolios. A convertible promissory note (“Note”) provides suchan opportunity to serve the needs of both the startup businessneeding capital and the investor seeking an opportunity.

Today, we are in the golden age of startups, where people areready to take risks for their dreams and passion. It takes more thanjust a great idea to run a successful business. Entrepreneurs andexisting business owners need capital to pursue their dreams.

New business ventures often have difficulty obtaining capital(whether for starting up, or for expanding operations). Todayduring economic downturns where standards for commercialinvestment are becoming water tight, a number of investors oftenseek non-traditional investment opportunities to enhance theirportfolios. A convertible promissory note (“Note”) provides suchan opportunity to serve the needs of both the startup businessneeding capital and the investor seeking an opportunity.


Convertible Promissory Note – A short-term debt that convertsinto equity. In the context of a seed financing, the debt typicallyautomatically converts into preference or equity shares upon theevent of a Qualified Financing. In other words, investors loanmoney to a startup as its first round of funding; and then rather thanget their money back with interest, the investors receive preferenceor equity shares based on the terms of the Note.

Qualified Financing: Most (if not all) Notes contain an automaticconversion clause that dictates the automatic conversion of theconvertible debt upon a “Qualified Financing.” The QualifiedFinancing is typically defined as an equity financing by the startup,for the purpose of raising capital, in which the aggregate of pre-determined amount is purchased by investors. Thus, the QualifiedFinancing event is the trigger by which the convertible debt willautomatically convert to equity. The conversion is considered“automatic” because it does not require the vote of either thestartup or the investor.

Convertible Promissory Note – A short-term debt that convertsinto equity. In the context of a seed financing, the debt typicallyautomatically converts into preference or equity shares upon theevent of a Qualified Financing. In other words, investors loanmoney to a startup as its first round of funding; and then rather thanget their money back with interest, the investors receive preferenceor equity shares based on the terms of the Note.

Qualified Financing: Most (if not all) Notes contain an automaticconversion clause that dictates the automatic conversion of theconvertible debt upon a “Qualified Financing.” The QualifiedFinancing is typically defined as an equity financing by the startup,for the purpose of raising capital, in which the aggregate of pre-determined amount is purchased by investors. Thus, the QualifiedFinancing event is the trigger by which the convertible debt willautomatically convert to equity. The conversion is considered“automatic” because it does not require the vote of either thestartup or the investor.


As a sweetener to the convertible debt investor, Notes have a conversiondiscount feature by which the convertible debt holder will exchange thedebt for Qualified Shares at a price per share equal to 80% (this amountcan very per deal) of the price per share paid by the Qualified Financinginvestors, so the Note holder gets more shares for his or her money.

One of the key advantages of Notes is that the valuation issue is kickeddown the road until the Qualified Financing – when there are a lot moredata points and thus it’s much easier to value the startup (i.e., price theround). Again, a Note is a loan (debt, not equity). A valuation of thestartup is thus unnecessary; and, if there is no valuation, there are noproblems of dilution, taxes and option pricing. With startups and smallcompanies, investors may not be financially savvy enough to properlyvalue a company. By using Notes, investors can forgo valuation until alater date when more sophisticated investors value the company andinject additional equity. Therefore, a Note allows companies to accesspotential equity financing with the lower upfront costs and efforts ofdebt.

As a sweetener to the convertible debt investor, Notes have a conversiondiscount feature by which the convertible debt holder will exchange thedebt for Qualified Shares at a price per share equal to 80% (this amountcan very per deal) of the price per share paid by the Qualified Financinginvestors, so the Note holder gets more shares for his or her money.

One of the key advantages of Notes is that the valuation issue is kickeddown the road until the Qualified Financing – when there are a lot moredata points and thus it’s much easier to value the startup (i.e., price theround). Again, a Note is a loan (debt, not equity). A valuation of thestartup is thus unnecessary; and, if there is no valuation, there are noproblems of dilution, taxes and option pricing. With startups and smallcompanies, investors may not be financially savvy enough to properlyvalue a company. By using Notes, investors can forgo valuation until alater date when more sophisticated investors value the company andinject additional equity. Therefore, a Note allows companies to accesspotential equity financing with the lower upfront costs and efforts ofdebt.


Recently a lot of startups have beenusing more Notes in angel rounds asthey make deals close faster. Bymaking it easier for startups to givedifferent prices to different investors,they help them break the sort ofdeadlock that happens when investorsall wait to see who else is going toinvest.

Notes allow more flexibility in price asvaluation caps for startups aren’t actualvaluations, and Notes are cheap andeasy to do. So you can do high-resolution fundraising: if you wantedyou could have a separate Note with adifferent cap for each investor.

Recently a lot of startups have beenusing more Notes in angel rounds asthey make deals close faster. Bymaking it easier for startups to givedifferent prices to different investors,they help them break the sort ofdeadlock that happens when investorsall wait to see who else is going toinvest.

Notes allow more flexibility in price asvaluation caps for startups aren’t actualvaluations, and Notes are cheap andeasy to do. So you can do high-resolution fundraising: if you wantedyou could have a separate Note with adifferent cap for each investor.


Are Notes an easy way ordoes it tout the startups?

Notes have a maturity date upon which the company can be forced into bankruptcy if ithasn’t closed a financing round. Convertible equity eliminates that threat. This is truein theory but extremely rare in practice. Unless the startup has been hoarding cash orinvesting it in hard assets in some unusual way, calling the notes won’t yield anyproceeds to the investor. Sometimes aggressive investors will ask to control the board ofdirectors or other things upon a payment default.

Notes accrue interest from the date(s) they are issued. This adds cost and administrativecomplexity, especially with multiple closings on different dates.

Yet startups have cranked out thousands of Notes for startups over the past severalyears, without any signs of the apocalypse (yet). Convertible equity strikes largely as asolution in search of a problem. The primary reason is that investors have everyincentive to work with the startup to extent or renegotiate the terms of the notes, becausethat represents their best shot at seeing any return on their investment.

Notes have a maturity date upon which the company can be forced into bankruptcy if ithasn’t closed a financing round. Convertible equity eliminates that threat. This is truein theory but extremely rare in practice. Unless the startup has been hoarding cash orinvesting it in hard assets in some unusual way, calling the notes won’t yield anyproceeds to the investor. Sometimes aggressive investors will ask to control the board ofdirectors or other things upon a payment default.

Notes accrue interest from the date(s) they are issued. This adds cost and administrativecomplexity, especially with multiple closings on different dates.

Yet startups have cranked out thousands of Notes for startups over the past severalyears, without any signs of the apocalypse (yet). Convertible equity strikes largely as asolution in search of a problem. The primary reason is that investors have everyincentive to work with the startup to extent or renegotiate the terms of the notes, becausethat represents their best shot at seeing any return on their investment.


Consult the Experts-ECA

There can be different structures for raisingfunds by startup, however, a startup shouldlook into the options which is best suitedfor your business.

To know the further details about RaisingFunds by Startups and other legal aspects ofstartups, contact us [email protected]

There can be different structures for raisingfunds by startup, however, a startup shouldlook into the options which is best suitedfor your business.

To know the further details about RaisingFunds by Startups and other legal aspects ofstartups, contact us [email protected]


convertible promissory note- raising fund by startups

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