"Convertible Notes" is what you most likely will hear the first time you get money for your first startup. They will give you cash asking to give them the convertible notes (or SAFE, which is very similar). Convertible notes are just a few pages of paper with two signatures at the bottom. Not too much to worry about. It's basically a contract between your startup and an investor. Let's see what exactly it says and what you, as a founder, should pay attention to.
Why Not Equity?
The first question is why convertible notes? Why not just shares of stock? And what the hell are "shares of stock" in the first place, right? Basically, there are two questions in each business or in any group activity, be it a new mobile app, a multi-national corporation or a bank robbery: 1) who is the boss, and 2) who gets the profit. To regulate that process "shares of stock" were invented (if you know who invented them and when, let me know).
Say we're planning to
rob a bank create a Facebook killer. There are three of us. We print three papers, each of which says: "whoever holds this paper has one vote and will get an equal part of the profit." How does that sound? Each of us has the same paper. When it's time to decide whether we use Java or PHP, we sit together, show our papers and vote. One vote for Java, two for PHP—the decision is made, we will use PHP. When our startup finally dies and it's time to decide what to do with the domain name, we sell it for $300 and give $100 to each holder of that paper, since there are just three papers and they have equal rights.
Thus, basically, each share of stock (this is an official name of that piece of paper) is a promise. A promise of some rights to vote and to make profit. The company (our startup) is making us a promise.
By the way, I can sell my share of stock to my friend. When it's time to decide whether it's Java or PHP, he will show up and vote. You may not like that, since you are seeing this dude for the first time, but you will have to obey—he's got that paper in his hands. That's why shares of stock are also called equity. I can sell them just like I can sell my car. No matter who owns them, he or she has exactly the same rights as the original or the previous owner. They are assets.
Usually, there are millions or billions of shares of stock. When a company starts, it prints, say, a million of them, giving 200,000 to each co-founder and leaving 400,000 in the so-called "pool." Later, an investor shows up and says: "I will put $500,000 to the bank account of the company and the company will print 300,000 more shares of stock for me." The amount of shares "issued" is growing. For example, at the time of writing there are 7.91 billion shares with Microsoft name of them. Microsoft Corporation has been printing extra shares nine times after their IPO in 1986. When Bill Gates founded the company in April 1975, he had 500K shares, which were equal to 50% (I'm guessing, do you know exact numbers?). Now he holds nearly 223M, which is just 2.8% of the total.
Now, the most annoying part. In reality, shares are not just pieces of paper with a few sentences on them, like in our example above. They are big legal documents that explain exactly how their holder can vote and exactly when and how he or she will get the profit. There are tons of legal clauses, which usually take weeks or months of discussions, between the company and investors. In reality, an investor says: "I will put $500,000 to the bank account of the company and the company will print 300,000 more shares of stock for me, terms and conditions of which my lawyer will discuss with you."
If we're talking about $500K, you will have no problem meeting that lawyers. However, if it's just $25K... To make life easier for smaller investments, convertible notes were invented (well, there were a few other reasons). They are not equity. Investors that have convertible notes can't vote. They can't sell convertible notes and they can't get any profit from the company. So, what they are for then? I'll explain in a minute. My goal so far was to show why young companies don't want to deal with shares of stock—because of greedy lawyers and, of course, the complexity of terms and conditions.
What are Convertible Notes?
They are just debts. They are not real investments. The company simply borrows money from an investor, promising to return them back. Why not just call them "money borrowing notes?" Because investors don't want their money back. They want equity.
So here is how it works. Say I'm an investor, giving you $25K. You give me convertible notes. Then we wait. We wait until a more serious investor shows up and gives you a bigger sum of money. And it's not just a matter of amount. What's important is that this investor must get shares of stock from you. This will be called "equity financing." You get finance and give away equity. When this happens, I show up, give you the convertible notes and you give me equity. On the same terms as you gave to that investor. I won't send you my lawyers, you won't discuss terms and conditions. You will just convert my notes to equity, on the same terms as agreed with that investor. Plain and simple.
A practical example. There is you and your co-founder. You guys have 1,000,000 shares of stock, 500K issued to each of you. I give you $25K, you give me convertible notes. In a few months, an investor comes in and your company issues 100,000 shares and sells them for $400,000 (your post a $400K check to the bank account of your company). This means that now there are 1,100,000 shares in total. You just sold 100K of them with the price of $4 per share. Now it's time to convert my convertible notes. You will have to give me 6,250 shares and I'll return you the notes. Thus, in the end, there will be 1,106,250 shares total and your company's post-money valuation will be $4,425,000. Got the math?
My shares will have exactly the same "rights, privileges, preferences and restrictions" as the shares you gave to the investor. And I won't have an option to negotiate. I will just receive them and accept.
One more thing. If that investor will never show up, you still owe me $25K. A debt is a debt.
Now, since we know what convertible notes are for and how they work, let's see what is important to pay attention to. There are just a few things, but they are really important.
The Valuation Cap
Let's take a look again at the example above. You are selling 100,000 shares for $4. This technically means that the shares the two of you had, before the investor showed up, suddenly got some value, right? They were just papers, but now someone is ready to pay $4 for each of them.
This means that each of you, being a holder of 500K shares, owns equity for $2,000,000 (I'm just multiplying 500K by $4). Also, this means that the valuation of the company is $4M. I'm just multiplying the total amount of shares, which is a million, by the price of each share. This valuation is also called pre-money valuation (the valuation before that $400K landed at your bank account).
There is also a post-money valuation, which, as you can imagine, is calculated by multiplying total amount of shares after the investment, by their price. In this case, it's $4.4M (1,100,000 by $4).
Let's see what happened in our example with my $25K. I gave them to you when your company was very young. Your valuation was rather low, because you barely had any results. You needed small cash to pay your bills and fill your car with gas. The valuation was definitely lower than $4M. So why are you converting my notes as if at the time of my investment the valuation was already that high. It's not fair. I want to get more than 6,250 shares. I want my part to be calculated as if your valuation was, say, $500K. In that case, I will get 20,000 shares. That's fair. The investor will pay $400K to get 100K shares, but I paid just $25K to get 20K of them. I earned more equity, because my risk was way higher.
To make that math happen, we put a "valuation cap" into the convertible notes. There will be a clause that guarantees that no matter what will be that pre-money valuation at the moment of "equity financing," in my formula it will stay $500K.
Obviously, for you as a founder, an ideal situation would be to have "no cap" convertible notes. That's the first thing you should try to insist on: no cap! Most investors will smile back and disagree. It's only logical. Then, try to negotiate the value of the cap. Try to make it as big as possible.
But remember, it's better to have money and a small cap than a big cap and no money. Does it sound too obvious?
Here is the same problem, but a different instrument. Again, as an investor, I don't like that you're selling me shares for $4. This is the price you are giving to the investor who came way later than myself. Their risks are way lower. I want a discount!
We can put a clause into convertible notes, which will say that the price for me will be same as for the investor at the moment of "equity financing," minus, say, a 50% discount.
Again, as a founder, you should insist on "no discount" convertible notes. Will I agree? Probably not. Especially if there is no cap. Try to negotiate a smaller discount. Maybe 10%, just to give me a feeling of appreciation.
Remember that by signing convertible notes and sending you cash, investors are basically lending you money. You owe that $25K to them. And some of them will ask for an interest. And the interest may be payable annually. Say, 5% per year. That means that you will have to send them a check for $1,250 every year, no matter how your startup is doing.
It's only logical for them, but is totally against you. Do not agree to pay any interest.
The Maturity Date
Some investors are ready to wait until that "equity financing" moment for as much as necessary. Others may demand you to pay them back on a so called "maturity date." Pay cash, with the interest. This date will usually be somewhere far ahead, like "three years from now." But don't feel too relaxed, this day will come faster than you expect.
Try not to give convertible notes with a maturity date to anyone.
SAFE is a form of convertible notes, introduced by YC, which doesn't have a maturity date at all. This technically means that you don't have to pay them anything back. Well, there is only one situation when you have to pay—in case your startup dies. In that case, you will have to pay investors as much as you can, using the cash you still have in your bank account. Most likely there will be nothing, so don't worry.
There are other less usual or less important elements of convertible notes, which you most likely won't ever see or should not worry about, like pro-data rights, for example. Just focus on the things listed above and you will be good.