Question

What is a convertible note? How does the issuer of convertible notes initially recognise the notes in its financial statements?

Answer 1

There are mainly two sources of getting funds in the early stages of business or startups. On the first hand, we always have EQUITY and on the other hand, we have the DEBTS. Equity is brought by the owners of the company or the people who became the owner either it was their it not by bringing capital. And Debt is brought or invested by the rich investors who are willing to wait for a certain period until they get paid back their sums with a certain rate of interest. Debt is a loan that's why it has to be paid back but there are some sort of Debts which may not be paid back. Those debts are known as convertible notes.

Convertible note is a very common early investment vehicle used for startup funding. Well, it is simply a short- term loan that an investor provides to a startup. It is a loan that is made with the intent that is not going to be paid back but with the intent that in the future it will convert to ownership in the company. Typically it will convert into stock or shares in the company. Generally, these notes are only offered to the angel investors for the additional risk of investing in the earlier round, convertible notes will sometimes have additional clauses, such as caps, and or discounts.

In the early stage of startup, it is very difficult to determine the value of the company and raise funds. Hence the primary advantage of issuing convertible note is that it does not force the issuer or the investor to determine the value of the company when they really might not be much to base a valuation on in such case the company may just be an idea.

There are a few key word that must be kept in mind :

Discount Rate -

This represent the valuation discount you receive relative to investors in the subsequent financing round, which compensates you for the additional risk you bore by investing earlier.

Valuation Cap -

The valuation cap is additional reward fir bearing risk earlier on. It effectively caps the price at which your notes will convert into equity and in a way provides convertible note holders with equity like upside if the company takes off out of the gate.

Interest Rate -

Since you are lending money to a company, convertible notes will more often then not accrue interest as well. However, as opposed to being paid back in cash, this interest accrues to the principal invested, increasing the number of shares issued upon conversion.

Maturity Date -

This denotes the date on which the note is due, at which time the company needs to repay it.

The issuer of convertible notes will put the amount of notes as an investment(asset) initially in its financial statement.