Startup Investment Terms
Convertible Note
This is a debt instrument that can later convert into equity. If the company receives subsequent funding, the holder of the note may convert the amount of their note into equity at a discounted price. If the company does not receive funding or get acquired prior to the maturity date of the note, the investor has the right to be repaid under the terms of the loan (principal + interest).
Using a convertible note requires a VC valuation of the company in a subsequent funding round to function optimally. If a VC firm values the company at Series A, the initial investor holding a convertible note can can convert the amount of the company’s debt to shares of stock at a discount to the price set by the venture capital valuation. The investor immediately holds something more valuable than what they paid for it and their risk is rewarded.
However, some startups won't take on venture capital mone -- a VC will never come in and value the business, and in turn, investors will not get the exponential payment on their investment. The startup is technically on the hook to repay the loan it received through the convertible note once upon the note’s maturity date (usually 12-24 months out) although investors may not be too aggressive in demanding repayment if it might mean bankrupting the company.
Convertible Securities
Convertible Securities (or Convertible Equity) are instruments to enable investors to purchase an equity stake that is determined in the future. They function like a convertible note, except without a debt component, meaning the company is not obligated to repay the amount of the investment as it would with a loan. Likewise, there interest does not accrue on the money that's held by the company. Convertible Securities are mostly used by startup accelerators/incubators to invest in companies participating in their programs.
Preferred Stock
This is class of stock with special rights and privileges attached. It offers greater protections for investors and often enables investors to influence company decisionmaking (e.g. by having seat on the board). See here for a more detailed overview of key terms that are negotiated in an angel preferred stock transaction.
Angel investors may want to invest with preferred stock over one of the convertible instruments noted above. Because there are more contracts to negotiate and execute, and more process to exercise, the use of preferred stock tends to be more expensive than using convertible notes. As such, convertible notes tend to be the more popular instrument for deals under $1 million.
If, however, preferred stock is used for smaller deals, simplified, streamlined versions of preferred stock financing documents, such as the Series Seed or AA documents are available. These documents omit some of the components of preferred stock financing documents that have less relevance at the early stage and defer some components to later preferred stock financings.