When a company is young, quantifying its valuation is often an arbitrary, pointless exercise. There may not even be a product in hand, let alone revenue. But companies at this stage may still need to raise money, and if investors decide on a pre-money valuation.
Convertible debt (also called convertible notes) is a financing vehicle that allows startups to raise money while delaying valuation discussions until the company is more mature. Technically debt convertible notes are meant to convert to equity at a later date, usually at a future round of funding. (Often notes convert to equity during a Series A round of funding.
Investors who agree to use convertible notes receive warrants or a discount as a reward for putting their money in at the earliest, and the riskiest stages of the business. In short, this means that their cash converts to equity at a more favorable ratio than investors who come in at the valuation round.
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