What is a Convertible Note (CN)? How to use it?

Convertible Note is an investment vehicle issued by startups. In the very simplest of terms, a convertible note (CN) can be thought of as such – an investor gives money to a startup in its first round of funding, and instead of acquiring shares upfront, he takes convertible shares, which can either be cashed out or converted to equity at a later date (basis some pre-agreed upon terms). Typically, CNs are issued when the valuation of the startup at the very early stages has not been established.

In India, as per the latest legislation, convertible notes can only be issued when: 

1. The investment amount is more than or equal to INR 25 lakh
2. The startup is DPIIT (Department for Promotion of Industry and Internal Trade), approved
   

To understand convertible notes better, let’s consider this simple example. 

Anirudh Sharma is an angel investor ready to invest INR 25 lakh in a seed-stage startup called Waky in July 2020. However, Waky is still very early, and it’s becoming difficult to arrive at a valuation for the company; thus, they cannot offer equity upfront to Anirudh. So instead, the two parties mutually decide to explore convertible notes. They decide that convertible notes worth INR 25 lakh will convert to equity shares with a 20% discount at Series A valuation. This means Anirudh will get a 20% discount on the price of each share at the time of conversion. In the worst case, if there is no round within the next 18 months, then the convertible note will mandatorily get converted at a predefined base valuation.

Fast forward to July 2021, Waky has done well, raised INR 2 cr, and its shares are now worth INR 10,000 each. Anirudh’s CNs will now convert along with the round, and he will receive shares at a 20% discount to ₹10,000, i.e., ₹8000 per share, so he will get ₹2500000/₹8000 = 313 shares in Waky. 

Why is this a win for Anirudh? 

• As an early investor, he was able to negotiate a good discount and therefore earned 313 shares of the company instead of 250 shares that he would have received at the round share price of ₹10000 (₹2500000/₹10000 = 250)
• If Waky had not succeeded and went south, Anuridh’s convertible note would have been settled before settling dues of ‘equity’ shareholders. 

Why is this a win for Waky? 

• The startup didn’t have to use up cash to return Anirudh’s investment. Instead, they issued him equity shares pretty much like any equity-based investment into the startup.
• Therefore, startups leverage convertible notes in early stages (where valuation can’t be determined) or during bridge rounds (where valuation is better deferred to a later date when the bigger VC round happens).

You might be wondering about the difference between convertible notes and CCDs. The key difference is that startups don’t require a valuation certificate to issue convertible notes.

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