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You’re an entrepreneur with a great idea. You paid for a market study that shows it’s a product that the public will buy. You have a short- and long-term business plan that bankers and financiers you have consulted say will work.
Unfortunately, you have the same problem that most prospective entrepreneurs have ― you don’t have enough capital to launch the business.
Many entrepreneurs solve this predicament by selling stock to investors, but that’s often easier said than done. How much is a share of your company worth? How can you persuade your first prospective investor to buy a share of your company when you have no proof or prospects that a significant amount of other people will also invest in the company?
Convertible notes can be the answer to your predicament. In fact, they are becoming an increasingly popular way of raising startup companies’ first funds, or seed money, according to an article in the popular website Mashable entitled “Convertible Debt vs. Equity: Which Is Right for Your Startup?”
Basically, it’s a loan from an investor to a company that can later be converted into stock. A convertible note is also often called a convertible bond or a convertible promissory note. “Economics For Dummies” describes a convertible note as a “bridge to get you from here to there, hoping that when you get there, investors will start investing.”
Kiplinger’s Personal Finance does an excellent job explaining how convertible notes work. The venture capitalist invests $5,000 in the company in exchange for the right to convert that money into 200 shares of the company’s stock at a later date. Thus, the startup company is raising the money it needs to begin operating.
At some point, the startup company is better able to assess how much to sell a share of stock for. By that point, it also might have enough seed money to spur other people to invest in the company. Thus, the company has benefited from “selling” convertible notes rather than stock in its first round of raising capital.
Investors who “bought” convertible notes instead of stock can also benefit from the startup company’s decision. If the stock is being sold for more than $25 per share ($5,000/200), the venture capitalist can convert the convertible note into stock and make a profit. If the stock price is $30 per share, the investor has already made $1,000.