This is probably the most common story/question that I hear from companies and entrepreneurs:
“I started my company a few months ago with my own money, stuff is going well (the product is live and we have acquired a few customers) BUT now we need more money (ideally from investors) to keep the company and our product progressing. How do we do that?”
All companies are different, but I would say that at least 75% of my clients started raising money from investors for the first time via “Convertible Promissory Notes”. There are other mechanisms for raising your first round of funding – Series Seed investment documents (http://www.seriesseed.com), SAFEs (https://www.ycombinator.com/documents), full blown National Venture Capital Association Series A investment documents (https://nvca.org/resources/model-legal-documents), among others – but certainly the most common method is issuing Convertible Promissory Notes to investors.
Issuing Convertible Promissory Notes is actually my preferred first funding method for clients for three reasons:
- Convertible Promissory Notes typically can be drafted quickly, which can be very helpful when a company is running out of money and needs investment documents drafted ASAP;
- Convertible Promissory Notes are as straight forward as a legal investment documents can be, which puts entrepreneurs’ and investors’ minds at ease; and
- Reasons 1 & 2 above mean smaller legal bills! I would much rather have my company clients spend their recently acquired funds on their products and growing their companies rather than my legal bills. And I’m truly serious about that.
If you’re interested in raising funds for the first time OR want to do a “bridge round” between a Series A financing and a Series B financing, I highly suggest Convertible Promissory Notes.
For your knowledge, by issuing Convertible Promissory Notes, your company will be issuing “debt”. BUT I do not view Convertible Promissory Notes as debt. I view Convertible Promissory Notes as equity because those Notes will most likely convert (cough first word cough) into equity (shares of your company) at a specified date, upon a sale of the company or upon your company’s next full blown Series financing.
Now, this article is not meant to be a deep dive into the mechanics of Convertible Promissory Notes, but here are some basic points that you should think about if you are interested in issuing Convertible Promissory Notes to investors:
- An investor will accrue “interest” on their investment, so you will have to agree on an interest rate with your investors – typical Convertible Promissory Note interest rates fall between 6%-10%;
- There will be a specified date when the Convertible Promissory Notes convert (the “maturity date”), so you will have to agree on a maturity date in the future with your investors – typical Convertible Promissory Note maturity dates fall between 6 months and 1 and a half years; and
- Convertible Promissory Notes will convert upon the next round of financing but there typically is a valuation threshold associated with that financing, so you will have to agree on that threshold with your investors – unfortunately, the thresholds can vary WIDELY based on company valuations.
There are other important features of Convertible Promissory Notes, such as conversion caps and the conversion discounts, but this article was meant to be the first step in your understanding of how fundraising works. Other follow up articles will come shortly from me and my colleagues, but if you have any questions before the next articles are published please do not hesitate to email ([email protected]) or call (205-254-1846).
Good luck with your new venture!