Convertible notes are the new trends for raising capital by startups, but how well do founders truly understand the implications of going down this route? This article outlines the basics of convertible note structures and runs through the pros and cons of using them to raise money for new entrepreneurial ventures.
Owning Of Shares
When we think about investments we typically relate them to the shares of an enterprise. In purchasing share or equity investments, a portion of the company is sold as equity (shares) for a desired sum of money but most of us are not aware of a convertible loan note. It doesn’t mean that the shareholder has owned the company, just that his opinion would matter in taking big decisions for the company. Generally, when a company sells its share to generate funds, there is no set schedule for the repayment of the shareholder, he gets an amount of total profit if made by the company and the investor generally counts on the company in making a profit. Investors also make money when the company decides on further liquidating their assets or shareholders can themselves sell or purchase shares. Another key point about equity investments is that because the investor is a part owner of the company, they typically have some sort of voting rights that govern various decisions of the company, generally referred to as board members.
Typically debt loans consist of the scheduled monthly payment of the principal borrowed and its interest, these scheduled payments are generally referred to as EMIs the whole amount is divided into monthly payments depending on how much the debitor can repay in a month, the timespan in which they are generally divided depends on the ability of the borrower to payback. When a person purchases loans he estimates the profit share he’ll be receiving by estimating the annual profit of the enterprise. At the early stages of a startup, investors are usually uncertain, and many lenders don’t want to take risks, as in early phases the chances of a startup failing are a lot more, and so funding startups is a risky game. Nevertheless, some institutional lenders provide funding to later-stage startups; these types of funding are generally referred to as a convertible loan note.
There are a few notable facts when it comes to convertible loan notes. In contrast to shareholders, debt holders do not have an ownership interest in the company and do not have voting rights that they no longer take part in the company’s decision-making and are not the board members of the company. However, when it comes to the priority of payments in converting the assets into cash, debt holders are paid before shareholders, generally, people believe that they are less riskier investments. the complexity of documentation and legal work that one undergoes in setting up various investments, it is easier and pocket friendly(about early business startups) to apply for a debt deal in comparison to shares.
Convertible loans are simpler to document. Many companies need to make transactions between bigger shares, hence making convertible loans an ideal vehicle for such transactions.