What every entrepreneur should know about convertible note financing

Singapore startup convertible note

Sooner or later, most promising startups will have to face the question of whether they should consider taking additional financing. There are numerous methods to raise money in the startup world, and Startup Legal Assistant will consider most of them in due time.

For today, we focus on convertible note financing in Singapore, a relatively popular method of raising money.

What are convertible notes?

A convertible note is basically short-term debt that potentially converts into equity (usually preferred stock) at such time a round of funding is raised. Think of it in this way – an investor lends money to a startup and has the option of receiving their money back with interest or converting their debt to shares of the startup. This conversion usually (but not always) involves a discount on the price determined during the subsequent round.

Advantages of using convertible notes

Part of the reason convertible notes seem to be gaining in popularity in Singapore is because these notes tend to be a simpler transaction to complete as opposed to the Series A financing. A simpler transaction means a lot less paperwork and a lot less money paid out to lawyers (Another example of a simple transaction/agreement gaining popularity in Singapore is the SAFE).

Most investors have their own proprietory ways of valuing a business and the valuation process doesn’t come cheap (in terms of time and lawyer fees). For smaller scale investments, it may not make as much economical sense.

At an early stage, where the startup really has nothing more than an idea and a couple of guys hoping to make things happen, it’s also very difficult to put any sort of real valuation to the startup.

By using the convertible note structure at this stage, the founders get to delay the discussion on how much the company is worth until the Series A round.

Disadvantages of using convertible notes

As mentioned earlier, discounts on share price are usually priced into the next round upon conversion.

In addition, the founders’ interests and the convertible note investor’s interests are not aligned for the subsequent (priced) equity round. Generally, the founders of the startup will benefit from a high valuation, so their shares will be diluted as little as possible. In contrast, the investor will benefit most from a lower valuation, as the investor gets the biggest percentage of the company for his investment this way.

A price cap on valuation in the convertible note agreement is a simple way to resolve this but this remedy is not without its difficulties.

Conclusion

A convertible note is an easy and inexpensive way for investors to invest in a Singapore startup without splitting hairs about the value of the company. While a convertible note can be issued by mid to late stage startups, it’s a particularly useful structure to consider when the company is at its very early stages, and the convertible note structure makes it an excellent one to use with investors of all kinds, including friends and family.