What is a convertible note?

<aside> 💡 Convertible note - a form of debt financing that allow investors to convert their loan into equity in the event of a priced financing round or liquidation event.

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Tips and tricks

• Typically, convertible notes are used in early-stage unpriced rounds, such as pre-seed and seed. Investors use them to avoid valuing a company until later, thereby avoiding a lengthy and costly legal process and enabling faster funding.

• Sometimes people refer to convertible notes as convertible promissory notes, convertible loans, or CLAs (Convertible Note Agreements).

• A convertible note is both debt and equity. It is recorded as debt on the company's balance sheet until the conversion event occurs. Afterwards, it becomes equity in the company.

• Convertible notes act like traditional debt if no conversion event occurs, with:

  • Interest rate. This is the interest rate of a loan, usually expressed as a yearly % of the remaining loan amount. Usually it’s about 5-7%.
  • Maturity date (Maturity). This is the date on which the final payment is due on a loan. Usually it’s set between 12 and 24 months.

  If conversion event occurs, conversion price determined by one of two things:

  • Valuation cap. This is the maximum valuation at which a convertible note will convert. The lower the convertible note valuation cap, the better the terms for the investors.
  • Discount rate. Instead of a specific valuation cap, a discount rate gives noteholders a discount to the valuation at the priced equity round when they convert. Usually it’s about 20-30%.

  In the case of both Valuation cap and a Discount rate, the conversion rate will usually be the lower of the two options - a good outcome for investors.

  • CLAs may have a Maturity Cap, a company valuation that converts to shares at the Maturity Date, unless an equity round has already occurred. This is often equal to or lower than the Valuation Cap, rewarding investors for investing in a young business.

• Unlike SAFEs, convertible notes may set parameters like a minimum amount raised for a priced equity round to trigger conversion.

• In liquidation, convertible noteholders have two options: liquidation preference 1-3x or convert the note to common stock at the valuation cap price.

• Convertible notes have a maturity date, and if a conversion event doesn't occur before then, the notes must be repaid. However, this is uncommon in practice, because startups usually lack the funds to do so. Thus, noteholders have 3 options:

  • Force a repayment and startup bankruptcy.
  • Extend the maturity date.
  • Convert the note to equity at Maturity Cap.

• Additionally, convertible notes may include other conditions, such as: investors rights (information, voting, board seating, pro-rata), use of funds, MFN clauses, etc.

Pros

1. Negotiations are simpler and can be wrapped up more quickly.
2. Founders can receive funding on a shorter timeline.
3. Founders postpone a valuation of a company until later.
4. Lower legal and administrative costs compared to priced equity rounds.
5. Retaining control of the company.

Cons

1. When the convertible note comes due, the investor will be granted equity in your business.
2. Convertible notes may have high interest rates, a costly burden for startups when repayment is due.

Deal example

• There are 2 founders: Steve and Ben. They build a startup called Smoogle. Steve had an operational background, so he serves as CEO. Ben, an ex-engineer, serves as CTO. They established the company in Delaware and issued 10,000,000 shares (basic number).

• Steve and Ben have agreed that Steve has received 6,000,000 shares (60% equity) and Ben has received 4,000,000 shares (40% equity). Take a look at how cap table appears:

  	Stocks	Number	Price / share	Equity
  Steve	Common	6,000,000	$0.00	60%
  Ben	Common	4,000,000	$0.00	40%
  Total		10,000,000		100%

• To cover seed expenses, they sought capital from ex-Google engineer and angel investor – Jessica. She invests $200,000 using a convertible note with the following terms:

  • Investments: $200,000
  • Valuation Cap: $4M
  • Discount Rate: 30%
  • Maturity Date: 12 months
  • Interest Rate: 5%
  • Maturity Cap: $3,2M

• Let's consider what happens if Smoogle doesn't raise a priced round before Maturity:

  • Smoogle should reimburse $210,000 ($200,000 plus 5%).

  • Jessica extended the maturity date by 12 months.

  • Jessica converts debt to equity using a Maturity Cap ($200,000 / $3,2M = 6,25%).

    	Stocks	Number	Price / share	Equity
    Steve	Common	6,000,000	$0.3	56,25%
    Ben	Common	4,000,000	$0.3	37,25%
    Jessica	Preferred	666,667	$0.3	6,25%
    Total		10,666,667		100%