Question: How does this work from the accounting side?

So, when the note is issued ($100K as per your example), we need to make a journal entry:

Cash (Assets): +100K
Long Term Notes (Liabilities): +100K

What’s the journal entry we need to make once the note
converts?

I assume:
Long Term Notes (Liabilities): -100K (to cancel the note)
Paid-in Capital (Equity): +100K?
Common-stock?: +25k?

This doesn’t balance. How do I account for the discount that the investor got? Any help would be greatly appreciated!

Incorporation * Startup Company Laywer: What type of entity should I form? (http://www.startupcompanylawyer.com/2009/03/12/what-type-of-entity-should-i-form/) * Startup Company Lawyer: What state should I incorporate in? (http://www.startupcompanylawye…

Any thoughts would be appreciated. Thanks.

My question is, if it bears interest, will it still be automatically converted to equity ? When can the interest payments stop ?

Could you also explain, what does warrant mean ?

If it becomes payable, isn’t this a highly risky form of capital raising for a seed stage startup? Things are so volatile at that stage that anything could go wrong!

These types of notes differ from a late stage PE deal re how interest is calculated and payment terms.

Or is it typically interest free, with the discount included as compensation for the forgone interest?

If it does include a coupon, then your Joe Angel example above misses out that minor detail, which could cost the startup say $5K every 6 months (assuming a 10% coupon, payable semi-annually).

Is that a correct assessment?

On a related but not direct subject – Dave McClure has great commentary of timing for Angel funding. This doesn't address structure, but when an investor is looking or should be looking to double down.

http://500hats.typepad.com/500blogs/2010/07/money…

Sorry for the linkout Ryan – But Dave McClure rocks.

What if I wanted to use this security as additional funding. Say the comapy secures $300k, which is delived in 2 stages. But when the time comes Investor in this case an institution fails to pay. Now 50% of the way is a really bad place for a startup. Syndication of investment for remaning $150K as a note seems like hte fastest way out of a bad position. But can be done?

thanks for all your comments. very informative..

I am interested to understand the risk in convertible note purchase agreements… If company A is looking for $10m series A investment but needs $300k (convertible note) angel investment to get through the early stages what guarantees are there that the series A will in fact happen? In other words, if i was the Angel investor i would want to be pretty certain that the series A would be going ahead once i had committed my $300k. The reason I ask is that I have unwittingly found myself as the middle man in such a deal and expect to profit from a finder's fee. I need to persuade would be Angel's that it is a good investment (the series A investment does indeed look 'likely' as far as the team putting together the proposal are concerned, but i guess as an outsider I would appreciate some advice on what to do to make the case as compelling as possible for the Angel Investor. I am sure Company A who are seeking the investment will pitch well when i connect them with possibles Angel's but i would like to understand the risk a little better and what i can do as the middle man to persuade would-be Angels that the risk is as low as possible..

Great article. I have an interesting situation where a guy wants to invest in my company with convertiple debt that converts at a fixed multiple of earnings in the future. Hes willing to wait for the third years earnings to convert based on. The company is an internet company that we are just taking out of the test marketing stage and starting to do a real big expansion. We could be very profitable but some of the issues that I'm worrying about is what happens if we reinvest all our money in the company and don't show any earnings and also am I entering into a deal where I may lose my shirt.

I know that I'm probably not giving enough information but I have never heard of this kind of a deal and I need some guidance.

Thanks,

Steven Wolf

I have lots of experience using convertible notes to raise capital in past startups. However, my current situation is a little different. I would like to actually service the debt as a regularly amortized payment as an option should the investor choose to never convert or if the other trigger events never take place. For the sake of example, let’s say the note is for $25k at 10% per annum, payable monthly with a 24 month term/maturity. It has regular tag-along/drag-along provisions customary with such notes (e.g., http://blog.lookery.com/wp-content/uploads/2008/08/generic-convertible-note.doc). In my case, rather than a discount conversion with a cap, I would like to issue warrant coverage and/or a warrant kicker as a sweetener that the investor can hang on to even if there is no future round and the note is paid in full and canceled as a result. How would you most simply address these points using a template like I’ve provided in the link above?

Keep up the great work!

Sean

(a) is probably unlikely, and (b) is a difficult negotiation, especially up front because then you have the valuation issue (which is probably why you avoided an equity financing to begin with). But if the startup can't agree to a conversion and repay the note, the investors could essentially call the note and force the startup into bankruptcy.

Extending the note for consideration (higher interest, additional security) may be an option. You could also modify the note to include a paydown schedule.