Raising Capital with Options and Convertible Notes
For growing businesses that need capital but are not ready for a full equity round, options and convertible notes offer flexible fundraising structures that balance investor interests with founder control. These instruments let you raise money now while deferring the valuation question until your company has more traction and data.
At Howard East, we structure convertible note and option agreements for companies across Illinois, Missouri, New York, and Wisconsin. Getting these instruments right from the start prevents disputes and protects both founders and investors when conversion events occur.
What Are Convertible Notes?
A convertible note is a short-term debt instrument that converts into equity — typically preferred stock — upon a triggering event, usually a subsequent priced equity round. The investor lends money to the company and receives the right to convert that loan into shares at a discount to the price paid by later investors.
Key terms in a convertible note include the interest rate, maturity date, conversion discount (typically 15-25%), and valuation cap. The valuation cap sets a maximum company valuation at which the note converts, protecting early investors from excessive dilution if the company’s value increases significantly before the conversion event.
When Convertible Notes Make Sense
Convertible notes work best for early-stage companies raising bridge financing or seed capital. They are faster and cheaper to execute than a priced equity round because you avoid the need for a full company valuation, detailed investor rights agreements, and extensive board governance provisions at a stage when the company may not have enough operating history to support a reliable valuation.
Understanding Stock Options
Stock options give the holder the right — but not the obligation — to purchase shares at a predetermined price (the exercise or strike price) within a specified time period. Companies commonly use stock options to compensate employees, advisors, and early contributors without immediate cash outlays.
For fundraising purposes, warrants function similarly to options and are often attached to debt instruments or issued as sweeteners in connection with lending transactions. The exercise price, vesting schedule, and expiration date are the critical terms that determine the value and utility of the instrument.
409A Valuations and Compliance
If you issue stock options to employees or service providers, Section 409A of the Internal Revenue Code requires that the exercise price be set at or above fair market value at the time of grant. This typically requires a 409A valuation — an independent appraisal of the company’s common stock. Failure to comply can result in significant tax penalties for option holders.
Structuring Your Raise
The choice between convertible notes, SAFEs (Simple Agreements for Future Equity), options, and priced rounds depends on your company’s stage, the amount you need to raise, and your relationship with investors. We help clients evaluate these options and draft documents that protect their interests while remaining attractive to capital sources.
Our attorneys also advise on securities law compliance, including exemptions under Regulation D that allow private placements without SEC registration, and state blue sky filing requirements.
Work with Howard East on Your Capital Raise
Raising money is one of the highest-stakes legal transactions a business undertakes. The terms you agree to now will affect your control, economics, and options for years to come.
Structure your raise correctly. Contact us or call 833-952-3111 to discuss your fundraising strategy.
This content provides general information about capital raising instruments. It does not constitute legal or investment advice. Consult qualified professionals before making financing decisions.
When to Use Convertible Notes vs. Stock Options
Convertible notes and stock options serve different strategic purposes in capital formation. Convertible notes are ideal for early-stage fundraising when establishing a company valuation is difficult or premature. They allow companies to raise capital quickly with minimal legal costs while deferring the valuation discussion to a future priced round. Stock options, by contrast, are primarily used to compensate and incentivize employees, advisors, and directors by giving them the right to purchase equity at a predetermined price.
Companies often use both instruments simultaneously — convertible notes to bring in outside investment and stock options to retain key talent. The interaction between these instruments requires careful planning to avoid excessive dilution and ensure that option holders and note holders understand how their interests will be affected at conversion. Working with experienced securities counsel ensures that the cap table remains clean and all stakeholders are properly documented.
Frequently Asked Questions About Convertible Notes
What is a convertible note and how does it work?
A convertible note is a short-term debt instrument that converts into equity during a future financing round. Investors lend money to the company, and instead of repaying the loan, the principal and accrued interest convert into shares at a discount to the price paid by new investors. Key terms include the discount rate, valuation cap, interest rate, and maturity date.
What is the difference between convertible notes and SAFEs?
Convertible notes are debt instruments with interest rates and maturity dates, while SAFEs (Simple Agreements for Future Equity) are not debt and have no maturity or interest. Both convert into equity at a future priced round, but convertible notes create a legal obligation to repay if conversion does not occur, whereas SAFEs do not.
How do stock options work for startup employees?
Stock options give employees the right to purchase company shares at a fixed exercise price, typically the fair market value at the time of grant. Options usually vest over four years with a one-year cliff, meaning employees must stay at least one year before any options vest. Once vested, employees can exercise their options by paying the exercise price to acquire actual shares.
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