"Unlocking the Benefits of Convertible Notes: A Comprehensive Guide for Indian Startup Founders"

What Are Convertible Notes?

Convertible notes are a form of short-term debt that startups use to raise capital. They provide an alternative to traditional equity financing from angel investors or venture capital firms in a company's early stages.

A convertible note allows startups to obtain cash quickly without having to determine a valuation or issue equity right away. The investor provides capital, usually between $50,000 to $500,000, in exchange for the promise that the loan will convert into equity at a later date. This helps startups raise funds without complex term sheets or the need to negotiate a valuation.

Essentially, a convertible note is a loan that converts into shares when a startup raises a priced investment round, typically a Series A. The conversion happens either automatically or at the investor's option. The investor also gets a discount on the conversion price compared to the round valuation. This benefits the investor if the startup has a higher valuation in the next round.

Convertible notes delay establishing a startup's valuation until a priced round, when there is more data available. This helps reduce the risks taken early on by both entrepreneur and investor. It provides capital to startups quickly when they need it most to build their product and growth.

How Do Convertible Notes Work?

Convertible notes are a form of debt that converts into equity. Here's an explanation of how they work:

• Convertible notes start off as debt instruments. An investor provides capital to a startup in exchange for a promise that the money will be repaid with interest in the future.
• Unlike a traditional loan, the convertible note does not have a maturity date where repayment is due. Instead, there is a conversion event trigger. This is usually a future financing round.
• When the startup raises a round meeting the criteria of the conversion event, the convertible notes convert into equity shares. The loan effectively turns into stock in the company.
• The conversion formula uses valuation caps and discounts to determine the equity stake percentage the convertible note investors receive.
• Valuation caps limit the startup's valuation for conversion purposes. With a lower valuation, noteholders get more equity share when the notes convert.
• Discounts also benefit convertible note investors. A common discount is 20%. At a $10 million post-money valuation with a 20% discount, convertible notes convert at an $8 million valuation.
• Interest of around 6% also accrues on the outstanding note amount before conversion. This interest usually converts into equity shares as well.
• In summary, convertible notes allow early investors to invest at discounted valuations compared to later equity rounds. The debt structure reduces early risks.

Advantages of Using Convertible Notes

Convertible notes offer several key advantages for startups raising early stage capital:

a.Speed and Flexibility

The documentation and process for issuing convertible notes is much faster and simpler than a priced equity round. Convertible notes can typically be executed in days or weeks, whereas a priced round may take months of negotiation. Convertible notes allow startups to quickly raise funds on decent terms when they need it. They also provide more flexibility in the timing and terms of eventually converting to equity.

b. Bridges Fundraising Rounds

Convertible notes serve as a bridge between different rounds of priced equity financing. Startups can raise convertible notes to bridge the gap between seed and Series A rounds. This allows startups to extend their runway and achieve business milestones before having to set a valuation and issue priced equity.

c. Aligns Incentives

Convertible notes help align incentives between investors and founders. With equity financing, valuations are set at the time of investment. But with convertible notes, the valuation is determined at the next equity round, avoiding messy negotiations. Investors' returns are linked to the startup's future success, since conversion to equity depends on whether the startup raises its next round and at what valuation. This incentivizes investors to add value and help the startup grow.

Disadvantages of Convertible Notes

Convertible notes come with some potential drawbacks that startups should consider before using them.

a. Debt Structure

Convertible notes are structured as debt financing. This means startups must pay back the convertible notes with interest, unless the notes convert to equity. If a startup is strapped for cash or unable to raise their next round, they may struggle to pay off the convertible note debt.

b. Lack of Governance Rights

Investors that provide convertible note financing do not receive voting rights or board seats like equity investors do. This means convertible note investors have less control and oversight into the startup's governance and direction.

c. Valuation Cap Negotiations

The valuation cap sets the maximum valuation the startup can have during conversion in the next equity round. However, investors may negotiate hard over the valuation cap amount, since it determines their potential equity stake. This can add complexity during the fundraising process.

Startups should carefully weigh if the advantages of quicker access to capital outweigh these potential disadvantages before utilizing convertible notes. The debt structure, lack of governance rights for investors, and negotiations over valuation caps can all create challenges down the road.

Convertible Note Terms to Understand

Convertible notes have some key terms that founders need to understand before agreeing to them. These include:

i. Interest Rates - Convertible notes may have an interest rate, similar to a loan. This interest accrues over the duration of the note. A higher interest rate is generally favorable for investors, while startups prefer lower rates. Typical interest rates range from 4-8%.

ii. Discount Rates - The discount rate determines the conversion price for when the note converts to equity. With a 20% discount rate, the conversion price is 20% below the valuation set for the equity financing round. This discounts the price paid by investors. Startups prefer higher discounts while investors want lower ones. Discounts often range from 15-30%.

iii. Valuation Caps - The valuation cap sets the maximum company valuation that will be used to determine the conversion price. With a $5 million valuation cap and a 20% discount, if the company raises at $10 million pre-money valuation, the conversion uses the $5 million cap. This benefits the startup by issuing more equity. Typical caps range from 50-100% of the current valuation.

iv. Maturity Dates - Convertible notes have a maturity date, usually around 12-24 months after issuance. On this date, the note converts to equity or the startup begins repaying the principal + interest. Shorter maturities favor investors while longer terms give startups more flexibility.

Understanding these key terms allows both entrepreneurs and investors to structure convertible notes in a mutually beneficial way. The specific details can have a big impact on dilution and returns.

Convertible Note Use Cases

Convertible notes are commonly used in the following startup funding situations:

a. Seed/Pre-Seed Funding

Many early stage startups use convertible notes for their initial seed or pre-seed funding rounds. At this very early stage, the company may not have much traction or valuation history. Convertible notes allow startups to secure funding without agreeing to a valuation and dilution upfront. The valuation is set later during a priced equity round. This helps early investors get better terms compared to if a valuation was set in the seed round.

b. Bridge Rounds

Startups can utilize convertible notes as a bridge between priced funding rounds. For example, if a startup plans to raise a Series A in 6 months, they may do a convertible note bridge round now to tide them over until the next round. The convertible notes allow the startup to delay setting a valuation and doing full due diligence until the Series A. Bridge notes can also help startups avoid down rounds if market conditions worsen between rounds.

c. Acquiring Startups

Convertible notes enable flexibility in acquiring early stage startups. Instead of agreeing to a purchase price upfront, the acquiring company can make an initial investment via a convertible note. This sets a valuation cap but delays actual valuation until a later equity financing event. It gives the acquirer more time to evaluate the startup's full potential. Convertible notes can make it easier for startups and acquirers to reach a deal.

Convertible Notes in India

Convertible notes have become an increasingly popular financing instrument for Indian startups over the past few years. As the Indian startup ecosystem has matured, both founders and investors have begun to recognize the benefits of using convertible notes versus standard equity deals for early-stage fundraising.

Adoption Trends

According to industry reports, the use of convertible notes has jumped sharply since 2017. While only 9% of pre-Series A deals in 2016 used convertible notes, this figure rose to 27% in 2018. By 2019, convertible notes accounted for a third of all pre-Series A startup financings in India.

This growth aligns with the rise of experienced serial entrepreneurs and sophisticated angel investors in India. As stakeholders gain familiarity with convertible notes as an efficient means of capital raising, their adoption continues to accelerate. 2021 saw over 120 convertible note deals despite the pandemic's impact on funding. Leading startups like CRED, Mensa Brands, and others have raised convertible notes ahead of larger equity rounds.

Notable Deals

Some of the largest convertible note financings in India include:

• Innov8 (2016): Raised $4 million from Venture Catalysts and others
• CRED (2018): Raised $25 million from Sequoia India, Ribbit Capital, and others
• Mensa Brands (2021): Raised $50 million from Accel India, Falcon Edge Capital, and Norwest Venture Partners

Major VC funds like Sequoia Capital India, Accel India, and Elevation Capital have become active investors in convertible notes across their portfolio startups.

Investor Perspectives

From an investor standpoint, convertible notes allow backing startups at lower valuations compared to priced equity rounds. The conversion discounts incentivize investors to participate early. Notes also carry lower legal costs than SAFEs or equity financing.

For follow-on investors, convertible notes offer more flexibility in setting valuation at the next round. Overall, convertible notes have proven popular among Indian angel investors and VC firms participating in pre-seed to pre-Series A startup deals.

Major Players in Indian Convertible Note Space

India's startup and investment ecosystem has seen increasing adoption of convertible notes over the last few years. Here are some of the key players enabling this:

Key Investors

• Accel Partners - One of the most active venture capital firms in India. Has invested in multiple startups using convertible notes, including Swiggy, UrbanClap, Flipkart.
• Sequoia Capital India - Leading VC firm with several convertible note deals such as Zomato, Practo, Grofers under its belt.
• SAIF Partners - Invested in Sharechat's $4 million convertible round in 2018. Also used notes for deals like Firstcry, Rivigo.

Law Firms

• Shardul Amarchand Mangaldas - India’s largest full-service law firm. Has advised many startups and VCs on convertible note financing.
• Khaitan & Co - Top law firm with significant expertise in convertible note transactions involving companies like Ola, Hike, UrbanClap.
• Nishith Desai Associates - Leading legal and tax counsel in convertible note deals like MakeMyTrip, Billdesk, Sharechat.

Notable Founders

• Deepinder Goyal - CEO of Zomato, which raised $60 million from VCs using convertible notes in multiple rounds.
• Abhiraj Bhal - Co-founder of UrbanClap, which raised capital from Accel, SAIF, others through notes.
• Namita Gupta - Co-founder of Zilingo, raised $8 million from Sequoia, others in a convertible note round.

Advantages for Indian Startups

India has seen a surge in startups and new venture creation in recent years. However, access to capital and fundraising remains a key challenge for many early-stage Indian startups. This is where convertible notes can provide major advantages.

Some of the key benefits of convertible notes for Indian startups include:

Aligns with Indian fundraising environment and trends

• Convertible notes fit well with the Indian startup ecosystem, where companies often raise capital in multiple iterative rounds from different investors over time.
• Notes allow startups to defer valuation negotiations to future equity rounds when they are better positioned for due diligence and setting a fair valuation. This avoids potentially unfavorable valuations in the earliest funding rounds.
• The iterative fundraising model also aligns with Indian investors' tendency to invest smaller amounts initially and increase investments over progressive rounds as milestones are achieved. Convertible notes work well within this model.
• Notes can help bridge funding gaps between equity rounds and provide capital on an on-demand basis to fuel growth between rounds. This caters well to the dynamic, fast-paced needs of Indian startups.
• The convertible note structure is relatively new to India but gaining popularity rapidly. It matches the trends of startup funding ecosystems globally.

Future Outlook and Predictions

The use of convertible notes in India is expected to grow significantly in the coming years. Here are some predictions for the future outlook of convertible notes:

• More early stage startups will utilize convertible notes instead of standard equity rounds. Convertible notes allow startups to get financing quickly without agreeing on a valuation. This flexibility is very appealing to early stage companies.
• The number of investors focused on writing convertible notes will increase. As convertible note adoption grows, more investors will allocate funds specifically for these type of deals. Angels, seed funds, and accelerators that invest at pre-seed and seed stage are likely to lead this trend.
• Conversion discounts will become more founder-friendly. As competition increases, investors will offer more attractive conversion terms to win deals. Discounts around 15-20% may become the norm compared to the current average of 10-15%.
• Conversion cap valuations will increase. With the growth of startup funding, conversion cap valuations will likely increase over time as broader industry valuations rise. A $10 million valuation cap today may shift closer to $15-20 million for companies at similar stages in the future.
• More complex deal structures will emerge. There will be innovation in deal terms and more complex structures like capped convertible notes and callable convertible notes. However, simple convertible notes will still remain the most common.
• Specialized players may arise for convertible note financing. Certain funds may emerge that focus specifically on convertible note investing as their core strategy. However, mainstream VC and angel funds will continue using notes as well.
• Notes will fund larger rounds. Convertible notes were traditionally used for smaller amounts up to $2 million. With growth in the space, notes may increasingly fund rounds in the $3-5 million range, while still reserving equity rounds for larger amounts.
• Level of founder education will increase. As more founders utilize convertible notes, knowledge sharing will help demystify these deals. Founders will be better equipped to negotiate terms and navigate the pros and cons of notes vs. equity.

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