If you have spent any time around bootstrapping startups, you will likely have heard talk about convertible notes (also called bridge financings). But what exactly are convertible notes and why do startups like them so much?
A convertible note works like this: an investor provides the startup with a loan, say $50K. If the startup gets funded during the term of the loan (usually 1-2 years), the investor gets repaid his or her $50K in preferred stock of the company, offered at a discount to the investor. If the discount is 20%, the investor will end up with $62.5K worth of preferred stock. If the startup does not get funded before the loan matures, the investor gets repaid the $50K plus interest.
What are the benefits of convertible notes? They are relatively simple to set up. For investors, convertible notes provide an opportunity to get a significant stake in the venture, if it is successful. For startups, convertible notes offer much-needed capital with little downside.
Takeaway is this: For startups that can persuade an investor to part with a relatively small amount of cash (generally upwards of $10K), convertible notes can be a great way to tide them over until they get Series A funding.