How can you structure a convertible note for seed funding?

? Market-Driven Rates: Set interest rates based on current market conditions. It is essential to strike a balance between offering market returns to your investors, and at the same time ensuring that your startup doesn't accrue interest. ? Consider the Term: Typically, the longer an investor has to wait for the note to convert, the higher the interest they'll expect. If you anticipate a longer runway before a funding event, then consider compensating with a slightly higher interest rate. ? Negotiate with Your Investors: Seed investors often prioritize equity upside over interest. Sometimes, a lower interest rate can be negotiated in exchange for other favorable terms, such as a lower valuation cap.

The interest rate for startup loans typically falls within the 4-8% range. It's important to note that investors don't expect this rate of return. In many cases, startups don't make regular interest payments due to limited cash flow. Instead, interest accumulates throughout the loan's term and is either paid at maturity or can convert into equity during an eligible equity round. the key is the conversion terms and whether its mandatory or voluntary

Instead of a single conversion event at the next funding round, tie conversion to milestones (e.g., revenue targets, user growth, or product launch). In my opinion, this gives investors early upside and founders flexibility in securing follow-on capital and could motivate founders to meet ambitious targets.

Maturity Date: Establish a maturity date, which is the date when the note becomes due if it hasn't already converted into equity. Typical maturity dates range from 18 to 24 months.

? Discount Rates: Typically, the discounts range from 10% to 30%. It's always a balancing act. Offer a good discount to reward early backers, but not so high that it heavily dilutes future equity. It could also potentially backfire in the subsequent rounds. ? Peer Comparison: Before fixing a discount rate, see what similar startups in your industry/space are offering. Being aware of market standards can help you make informed decisions. ? Review: As your startup grows and the landscape changes, consider revisiting the terms. Early backers are always partners in your journey. Open dialogue with them ensures terms remain fair.

When convertible notes transition to equity in a qualified financing round, note holders receive an advantage. They not only consider their original principal amount but also the accrued interest when determining the number of shares they receive. they also get a discount on the price per share . This discount serves as an incentive for early investors. For example, if the discount rate is set at 20%, and the new equity in the qualified financing is offered at $2.00 per share, the convertible note's principal plus accrued interest would convert into shares at a rate of $1.60 per share. This mechanism encourages early backers by providing them with a more favorable conversion rate, acknowledging their early support for the startup.

Incorporated within convertible notes, one finds an essential feature beyond the conversion discount - the valuation cap. This component serves as a stringent upper limit on the conversion price, shielding noteholders from unfavorable terms in the next equity financing round. In situations where a qualified financing does not transpire, any automatic conversions at the maturity date usually take place at a price per share lower than the predefined valuation cap. This mechanism offers protection and ensures that investors receive a fair and predetermined share price, irrespective of the subsequent equity round's conditions.

Convertible notes are originally structured as debt investments, but have a provision that allows the principal plus accrued interest to convert into an equity investment at a later date. This means they are essentially a hybrid of debt and equity.

Principal Amount: The initial loan amount provided by the investor. Interest Rate: The interest accrued on the principal, often lower than market rates. Maturity Date: The deadline for the loan repayment, usually after 12-24 months. Conversion Discount: A discount rate applied when the loan converts into equity, benefiting the investor. Valuation Cap: A maximum valuation at which the loan converts into equity, ensuring early investors get a fair share. Events Triggering Conversion: Events like the next funding round trigger conversion into equity. Repayment Terms: Clear terms for repayment if conversion doesn't occur by the maturity date. Conversion into Equity: At the trigger event, the loan converts into preferred shares in the company.

Convertible notes offer advantages. They simplify terms, streamlining negotiation and due diligence, saving time and reducing legal costs. They're widely understood, facilitating quick financing. They grant operational freedom to founders, as note investors don't control the company. Importantly, convertible notes postpone formal valuation until the next financing round, ideal for early-stage startups lacking solid sales or growth data. The valuation cap and discount provide an approximate valuation reference.

Conversion Trigger: Determine the events that trigger the conversion of the note into equity. Common triggers include a qualified financing round (a specified funding threshold in an equity round), a change of control, or the maturity date. Covenants: Include any additional covenants that protect the interests of both the investor and the startup. These could address issues like information rights, governance, or affirmative and negative covenants.

In structuring a convertible note for seed funding, it's crucial to balance financial elements with transparency, aligning terms with your long-term vision, and respecting investor perspectives. Clear, understandable terms build trust, a vital asset in early-stage relationships. Consider how note terms impact future financing and exit strategies to avoid conflicts. Acknowledge investor expectations and contributions to foster a positive partnership. Balancing these aspects ensures not only immediate funding but also a solid foundation for your startup's growth and long-term success.

Easy to use but problematic if the time between loan payment and the conversion date is long or unpredictable. Under certain legislation, including that in force in Switzerland, it is necessary to ensure that the equity is not exceeded by more than 50%, otherwise the conversion can no longer be carried out. In this eventuality, it would first be necessary to carry out a capital increase before the conversion.