How to Fund Your Startup in Canada Using a Convertible Note

DISCLAIMER

This information is intended for business owners in Canada and serves as general guidance only. Always consult with a qualified advisor before making any legal decision. 

In this article, we’ll cover the following topics:

• What convertible notes are and how they work

There are countless ways to fund a startup. One method is what’s called a convertible note. Though complex, convertible notes can provide certain benefits for founders, such as  – so let’s dispel the confusion. 

What’s a convertible note?

There are two ways a company can raise capital: either they take loans from a bank (or friends, or family), or they issue equity in their company. 

A convertible note combines these two methods of raising capital. A convertible note is essentially a short-term loan or debt instrument that can be converted into company equity later on if the lender chooses to do so. Convertible notes have all the features of regular loans – interest rates, maturity dates, and so on, but these notes are also convertible by virtue of the fact that, upon the occurrence of a conversion event (often a future round of financing, or a threshold amount of financing raised or the acquisition of the company by another entity), they can be converted into equity in the company at an attractive discount.

For example, if the loan amount was $50,000, and the discount attached is 10 percent, the investor has the potential to receive $55,000 worth of shares in the company upon the occurrence of a conversion event. 

A convertible note also permits you to kick the can down the road on valuating your company. Rather than deciding today that your company is worth $10m and each share worth $1, you can elect to determine the valuation at a later date. For most early-stage companies, both investors and founders recognize that pre-revenue valuations of their company is arbitrary. 

It’s easy to see how investors can benefit from convertible notes, but how does your startup benefit? First, they allow you to retain all of the equity in your company – at least until whenever (if ever) the investor decides to cash in and take some shares. Depending on the terms of the convertible note, you may be permitted to repay your investor rather than issue shares to them - so, if your company takes off rapidly and you’d rather keep all the equity off the table, then that option can be available to a founder. Second, they provide a practical way of attracting investors early on at a time when company valuation is difficult to calculate. 

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