What is a Convertible Note?
A Convertible Note is a form of short-term financing wherein the loan converts into equity rather than being repaid in cash.
Startups rarely qualify for traditional debt financing from banks and other senior lenders, meaning traditional bank loans are out of the question.
However, the conversion feature of hybrid securities such as convertible notes (i.e. debt → equity) and discounted pricing act as an incentive for investors to take on the added risk.
Convertible Note: Startup Financing Offering
A convertible note is a frequent form of early-stage financing offered by startups to raise capital from investors.
Convertible notes are a type of loan issued by startups that convert into equity once a “triggering event” occurs.
Usually, the triggering event will be the startup’s next round of financing that exceeds an agreed-upon minimum threshold, i.e. “qualified” financing round.
The first investor money raised by startups is typically raised through the sale of convertible notes or perhaps a SAFE note.
The potential reward (i.e. the “upside”) from traditional bank loans is not adequate when applied to a startup with an uncertain future.
But for convertible note issuances, if a high-risk startup performs well, the post-conversion shares that the investors now hold are worth much more than the original loan principal, serving as an additional incentive (i.e. reward for risk) for the investors.
How Convertible Notes Work (Step-by-Step)
Convertible note issuances are designed to convert into ownership in the issuer upon a subsequent round of qualified financing.
- Step 1 → Convertible Note Raise: The convertible noteholder lends capital to a startup – typically the first form of capital raised by the startup – ignoring the capital contributed by the founders and loans from friends and family.
- Step 2 → Accrued or Cash Interest: As part of the convertible note financing agreement, the noteholder earns interest while the loan is still outstanding, which is typically a short period (i.e. one to two years at most). But since the amount of cash on hand is minimal, the interest is ordinarily paid in the form of an accrual, i.e. the interest is added to the principal rather than paid in cash.
- Step 3 → Conversion: With traditional debt financing, the borrower is contractually obligated to repay the principal on the maturity date. But for a convertible note, the hybrid instrument converts into equity – with the conversion date contingent on the occurrence of a specified event, such as the subsequent round of qualified financing (i.e. the “triggering event”).
Convertible Note Financing Terms
Like traditional loans from banks and lending institutions, a convertible note is a contract with set terms that must be agreed upon between all parties involved.
Convertible notes must sufficiently “reward” the investor – considering these capital providers took on the most risk by investing in the startup the earliest – by setting terms giving them the option to buy discounted shares.
The most common terms are the following:
- Maturity Date: The agreed-upon date at which the note comes due – most often 12 to 24 months post-issuance – at which the security converts into equity or must be repaid in cash.
- Interest Rate: The coupon rate is typically lower than that of traditional loans due to the conversion feature and often accrues to the principal amount rather than being paid in cash.
- Valuation Cap: The “ceiling” value of the company used to determine the conversion rate, i.e. the upper maximum parameter.
- Discount Rate: The discount at which the note holder can convert their investment at a price per share lower than those paid by other investors (and usually ranges around 20%).
Convertible Notes Interest Rate (%)
Convertible notes are a hybrid between debt and equity. Like debt, interest (i.e. the coupon) on convertible notes must be paid periodically.
The lender will most likely be seeking the majority of their returns to stem from the equity upside rather than cash interest, so they typically will not charge high interest rates in cash to allow the startup with more breathing room.
The flexibility of convertible notes, such as avoiding the cash interest component, is a distinct feature – but it does not come without a price, e.g. the interest accrues to the principal amount instead of being paid in cash.
Convertible Note Caps: Valuation Cap
The terms of the convertible note specify the valuation cap, which effectively functions as a “ceiling” at which their investment converts, i.e. the notes must convert at either 1) the cap or 2) the discount.
The established “ceiling” also gives the noteholder a “floor” concerning their ownership stake (%) post-dilution.
Because of the valuation cap, the noteholder can estimate whether the money will convert from loan to equity at or below a specified price per share set by the valuation cap’s parameters.
In the absence of a cap or discount, the notes would convert into the issuing company’s shares at the same price as the participating investors in the round. In such a case, there is no real incentive for the noteholder, i.e. no benefit to being an early investor.