Basics of: Convertible Instruments

Looking to accelerate your fundraising whilst minimising complexity? Convertible instruments could be the strategic advantage you need. These versatile financing tools provide an efficient pathway to capital, enabling you to concentrate on your core mission: growing your enterprise.

This comprehensive guide provides the critical knowledge required to understand and harness convertible instruments effectively.

Defining Convertible Instruments

Picture this: you've developed an innovative solution for a pressing market need, and you're ready to launch a company. You require capital to assemble a team, secure infrastructure, and execute your go-to-market strategy.

One fundraising approach involves conducting a priced equity round, where ownership stakes are sold at a defined company valuation. However, establishing an accurate valuation for nascent ventures presents considerable challenges, frequently requiring protracted negotiations and extensive due diligence.

Enter convertible instruments: rather than transferring immediate ownership, you offer investors the right to receive shares at a predetermined future milestone through instruments such as convertible notes or SAFEs (Simple Agreements for Future Equity).

These instruments function as temporary financing mechanisms where capital provided today transforms into equity ownership at a subsequent date, typically triggered by a qualified funding round.

The Strategic Value for Early-Stage Ventures

Convertible instruments deliver multiple strategic benefits for both emerging companies and their backers:

Expedited execution and reduced costs: Compared to traditional equity financing, convertible instruments close more rapidly with simplified negotiation processes. This translates to reduced legal documentation requirements and lower transaction expenses.

Postponed valuation discussions: One of the most significant obstacles for early-stage companies is determining appropriate valuation. Convertible instruments defer this complex determination until a later financing event, when you possess stronger metrics and market validation to support your company's worth. This prevents potentially disadvantageous early-stage valuations.

Adaptable structuring: Convertible notes and SAFEs provide flexibility in investment structuring, enabling you to customise terms for different investor profiles over an extended period, rather than requiring simultaneous closings.

Ownership preservation: By utilising convertible instruments, founders avoid immediate equity dilution, maintaining greater control during critical early development phases.

Distinguishing Between Convertible Notes and SAFEs

The fundamental distinction between convertible notes and SAFEs lies in their legal classification: convertible notes are debt instruments, whilst SAFEs are not. This structural difference creates important practical implications.

A convertible note represents a loan to the company. Like traditional debt, it accumulates interest and includes a maturity date—a deadline for repayment. However, rather than cash repayment, the loan converts into company equity, typically at a discount to the share price in the subsequent funding round, rewarding early supporters for their risk tolerance.

The maturity date can create pressure on companies to complete a priced round before the note becomes due, as failure to do so could require cash repayment—a challenging scenario for capital-constrained startups.

A SAFE, conversely, is not a debt instrument. It represents a simpler contractual agreement establishing that, in exchange for immediate capital, equity will be issued at a future triggering event. SAFEs do not accumulate interest and lack maturity dates. This makes them more straightforward and often faster to negotiate than convertible notes.

Because SAFEs don't create debt obligations, there's no risk of forced repayment if a priced round doesn't materialise by a specific date. This absence of maturity deadlines provides enhanced flexibility for the company.

These differences typically make SAFEs more founder-friendly, though investors may prefer convertible note structures in certain circumstances. The positive news is that companies can issue both SAFEs and convertible notes simultaneously, tailoring each instrument to match individual investor preferences and requirements.

Impact on Subsequent Financing Rounds

Convertible instruments can significantly influence a startup's future fundraising trajectory.

One critical consideration is the valuation cap. This ceiling on the conversion price protects early investors from excessive dilution if the company's valuation increases substantially before the next priced round. However, a low valuation cap can become problematic when the company performs exceptionally well. If the subsequent round's valuation significantly exceeds the cap, the convertible securities convert as though the valuation equalled the cap, potentially signalling to new investors that the company's actual value might exceed initial perceptions. This dynamic can constrain the capital available or influence deal terms, as new investors may hesitate if they perceive earlier investors undervalued the opportunity.

The discount rate, which incentivises early investment, also plays a crucial role. Whilst discounts attract initial capital, a substantial discount rate can significantly dilute founder and later-stage investor ownership. New investors may be less enthusiastic about participating if a considerable equity portion is designated to convert at discounted prices for earlier backers. This can complicate securing new investment or force founders to surrender larger ownership percentages to compensate. The cumulative effect of multiple convertible instrument rounds, each with distinct discounts and caps, can create a complex and potentially problematic capitalisation table as the company pursues larger, later-stage funding.

Finally, the choice of convertible instrument matters. Convertible notes, being debt instruments, accrue interest, creating a liability on the company's balance sheet. Whilst typically settled in equity upon conversion, this financial obligation remains a consideration for potential investors. SAFEs, conversely, are simpler agreements without accrued interest or maturity dates, avoiding this particular concern.

Contact Vested for Advice

Managing the intricacies of convertible instruments and ensuring their terms are clearly documented and understood is essential for smooth future fundraising. Whilst convertible instruments provide a valuable bridge to subsequent funding, careful consideration of their terms and potential long-term consequences is critical for sustained success.

Whilst this overview establishes a foundation, every startup's situation is unique, and the optimal approach requires careful evaluation of your specific circumstances. Don't leave these critical decisions to chance. At Vested, our experienced team of startup legal experts can provide the personalised guidance you need to structure your funding strategy for maximum benefit.