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For many early stage companies seeking to raise capital to fund their operations, the conversation often revolves around “how much equity must we give up.” This point leads to awkward discussions regarding valuation at a time when the venture still is validating its business model. Convertible notes allow start-ups to secure necessary funding while avoiding the difficult valuation discussion until the business has created significant equity value and is truly ready for an equity issuance.

Also known as convertible debentures, convertible notes are an effective tool for funding startups that need seed capital, while continuing to develop their business model. In most instances, these instruments are unsecured loans from investors, who will either be paid off as the business develops or see their notes converted to equity shares, typically in conjunction with the close of Series A equity round.

Convertible notes have multiple advantages. These debentures are very cost-effective and quick to implement. It takes just a matter of days to turn around the paperwork, with substantially less expenditure on legal fees relative to other types of debt and equity investment. Convertible notes are such an important tool for early stage ventures, because they allow companies to validate their concept in the marketplace before addressing valuation, a must when issuing equity shares. When management gives up equity too early, there is potential to undermine the incentive of the team tasked with ramping up the company. Founders may also hold on to their equity ownership percentage over a longer period as they increase the overall value of their venture, thus avoiding significant dilution at an early stage during the company’s existence.

Let’s take a closer look at certain common features of convertible notes. These debentures, by definition, convert into equity at a future date, based on certain conditions being met. For example, notes may convert automatically when a certain amount of equity is raised, or at the option of either the holder or the issuer. Convertible notes typically accrue interest that is added to the principal balance at the time of conversion.

A big incentive for early investors to loan money through a convertible note is the discount feature. Convertible notes typically offer a discount upon conversion, meaning that investors are able to purchase their equity at a much lower price (typically 15 – 25 percent off the eventual issue price), for their willingness to help the company early in its life. For example, suppose an investor group purchases a $100,000 convertible note with a 20 percent discount feature from Company A and the next round of equity investors valued Company A’s shares at $1 per share. The note would convert at a price of $.80 per share, meaning that the note investors would own 125,000 shares of Company A stock ($100,000 divided by $.80 per share).

Additionally, we sometimes see a valuation cap put in place, enabling early stage convertible note investors to know a maximum share price at conversion. A valuation cap effectively puts a maximum valuation on the company for the purposes of determining the conversion price. Suppose an investor group purchases a $100,000 convertible note with a $1 million valuation cap from Company B. If the Series A equity investors subsequently value Company B at $2 million dollars then the note investors will convert at a price of the $.50 ($1 million valuation cap divided by the $2 million valuation). As a result, the note investors will receive 200,000 shares of Company B stock ($100,000 divided by $.50 per share).

For the issuer, convertible notes offer a lower financing rate, usually in a range of six to 10 percent depending on the discount rate or valuation cap offered at conversion, than typical mezzanine financing rates, which have rates in the mid-to-high teens. It’s also important to note that convertible debentures are meant to be short-term in nature, with maturities ranging between 12 and 36 months.

Convertible notes are private placements, subject to the Security and Exchange Commission’s Regulation D requirements. As such, they are limited to “qualified” investors, who are either accredited (unlimited number) or deemed to be sophisticated (up to 35). Accredited investors must meet one of the two following criteria: (i) have a net worth (excluding the equity in their primary personal residence), individually or jointly with a spouse, exceeding $1,000,000 or (ii) have individual income of at least $200,00 per year for the past two years or joint income with a spouse at least $300,000 per year for the past two years and have reasonable expectations that their income will exceed the minimum threshold for the immediate future.

Sophisticated investors are defined by the SEC as those individuals who possess the requisite knowledge and experience in financial, investment, and business matters for evaluating the merits and risks of any investments on their own behalf (think CPAs, MBAs, chief financial officers, bankers, financial advisors).

Finally, there are a few key points of consideration for both issuers and investors. Chief among these points is determining the triggers for automatic conversion of the promissory notes into equity securities. Also important are determining conditions for a not uncommon scenario: how should these investments be treated in the event that the company is unable to complete a subsequent equity raise? Lastly, an issuer must consider the potential tax implications arising from the conversion and accrued interest features associated with the note.