What is a convertible promissory note?
Introduction
Imagine you want to start a new business, like a bakery. You need money to buy ovens, ingredients, and rent space. You could ask friends and family for help, or you might go to a bank for a loan. But what if you're a startup with no credit history? You might instead try to sell a special kind of promise to investors. This is exactly what Faraday Future did when it raised $25 million in funding.
What is it?
A convertible promissory note is a fancy way of saying a 'promise to pay' that can be converted into shares of a company later. Think of it like a IOU that has a special feature: instead of just paying back the money, the investor gets shares in the company at a future date.
Here's how it works:
- Investors give money to a company (like Faraday Future)
- The company gives them a promissory note (a legal document saying they owe the money)
- This note has a special clause that lets it be converted into company shares at a later date
- When that date comes, the investor gets shares instead of cash
How does it work?
Let's use a simple example to understand how this works:
Suppose you're a friend of a new coffee shop owner. You give them $1,000 today. They give you a note saying, "We'll pay you back $1,000 in a year, but if our business does well, you'll get shares in our company instead."
Later, when the business is successful, the coffee shop might be worth $10 million. The note can be converted into shares worth $1,000. If the shares are worth $10 each, you get 100 shares instead of your original $1,000.
But there's a catch: the conversion usually happens at a discount. So if the company's value is $10 million, you might get shares worth $1,000 at a 20% discount, meaning you get more shares than you would have if you bought them at the current price.
Why does it matter?
For companies like Faraday Future, convertible notes are a smart way to raise money when they're not yet ready to go public (sell shares to the general public). It helps them avoid the complex and expensive process of a full stock offering right away.
It also allows investors to get into a company early, when the valuation is lower, and potentially benefit from the company's growth. It's like getting a ticket to a concert at a discount, but with the chance that the ticket might be worth more later.
For Faraday Future, raising $70 million in just two months shows strong investor interest in their robotics plans. But it's important to note that these convertible notes are not the same as regular stock. They're more like a loan that can become equity.
Key takeaways
- A convertible promissory note is a promise to pay back money that can be converted into company shares later
- It's a common way for startups to raise money before going public
- The conversion usually happens at a discount, which benefits investors
- It's not the same as regular stock, but can become stock later
- Faraday Future used this method to raise $70 million for its robotics business
In simple terms, a convertible promissory note is like a loan that might turn into ownership in a company. It's a clever financial tool that helps young companies grow while giving investors a chance to benefit from future success.
