What is a convertible note?

What is a convertible note?

A convertible note is a form of debt instrument that converts into equity, typically in conjunction with a future financing round. It is treated like a debt instrument until conversion takes place. It is commonly used to bridge the financing gap, so the company can reach the next successful financing round.

Being a form of debt instrument, its liquidation preference commonly ranks above all other equity classes. This is a large assurance to investors if the company is unable to materialize their expected valuation growth.

When do companies issue convertible notes?

The common scenarios in which convertible notes are issued are:  

1. The company successfully raised the required amount of capital to meet its pre-set target.

2. The loan's agreed term ends.  

3. The company is sold or acquired.  

How do convertible notes work with example?

In simple terms, investors often lend money to a startup during its early funding stages. Later on, the company has two options: it can either repay the loan with interest or convert that loan into equity once the company has grown and its value becomes clearer.  

These types of notes allow startups to raise funds without having to publicly fix a company valuation right away. Instead, both the investor and the company privately agree on the company's value. This approach offers flexibility, letting both sides structure repayment and equity conversion terms in a way that works best for them.  

To illustrate how this works, suppose an investor lends a startup $150,000 at a 10% annual interest rate under a convertible note with a one-year maturity.  

If no priced funding round occurs in one year, the startup must repay $165,000 (principal plus interest).  

The way a convertible note works depends on whether the company undergoes a conversion event.  

If no conversion event occurs, the note acts as regular debt, with interest and a maturity date for repayment.  

However, if a conversion event occurs, the note isn’t repaid in cash. Instead, it converts into equity. The total amount that converts includes both the original principal invested and any interest that has accrued to that point.

The price at which the convertible note converts into equity will be determined by one of two factors:

• A valuation cap sets the highest company value for note-to-equity conversion.  

For example, if a note has a $4 million valuation cap and the company later raises a priced equity round at an $8 million post-money valuation, the noteholders don’t convert at $8 million. Instead, they value the company at $4 million. This means they receive shares at a more favorable price.  

A lower valuation cap benefits investors, letting them get more equity for the same investment.  

• A discount rate allows noteholders to convert to equity at a reduced price in the next funding round, rather than using a fixed valuation.  

For example, if the note carries a 40% discount and the company later raises a priced round at a $10 million post-money valuation, the noteholders would convert as if the company were valued at $6 million. In simple terms, they get to buy shares at a 40% discount to the valuation for new investors in that round.  

With both a cap and a discount, investors use whichever gives them the lowest conversion price.  

If a liquidation event occurs, investors may either get a payout or convert their notes to shares, as agreed.  

(i) Option 1: The investor can choose to receive a multiple of their original investment, typically between 1x and 3x. This is called a liquidation preference. For instance, if the liquidation preference is 2x, the investor would receive twice their original investment if a liquidation event (such as a sale of the company) occurs. So, if they invested $1 million through a convertible note, they would be entitled to $2 million upon the company’s sale.  

(ii) Option 2: Instead of taking the liquidation payout, the investor may choose to convert the convertible note into common shares. The conversion price is usually based on the agreed valuation cap. After conversion, the investor would sell those shares as part of the acquisition and receive proceeds in proportion to their ownership, just as any other shareholder would.

What are the advantages of convertible notes?

Here are the advantages of convertible notes:

• ‍Simpler and more cost-effective to execute: Convertible notes are generally easier to structure from a legal standpoint. Because the documentation is simpler than for a full equity round, they tend to close faster and incur lower legal fees.

• ‍No need to immediately decide on valuation: With convertible notes, you don’t have to set a formal company valuation upfront. This can be especially helpful for early or seed-stage startups that don’t yet have enough operating history or financial data to confidently determine the business's value.

• ‍Useful for bridge or interim funding: Convertible notes work well as bridge capital, meaning they can help a company raise funds between larger financing rounds. They’re also practical for intra-round financing when a startup needs additional capital before closing a priced round.

• ‍Allows founders to retain more control (for now): Since convertible notes are not immediate equity financings, founders typically don’t have to give up board seats or voting rights right away. In contrast, during priced equity rounds, lead investors often request a board seat, and preferred shareholders usually receive voting rights. Convertible notes can therefore help founders maintain greater control in the short term.

What are the disadvantages of convertible notes?

Here are the disadvantages of convertible notes:

• ‍May lead to higher-than-expected dilution: If you raise a large amount through convertible notes or if those notes convert at a much lower valuation than your future equity round, you could end up giving away more ownership than you initially anticipated. This can reduce your stake in the company more than you expected as a founder.

• ‍You may still need to settle on an effective valuation: If you include a valuation cap in a convertible note or SAFE, you’ll eventually have to agree on a reference point that acts like a pre-money valuation. In other words, you’re not completely avoiding the valuation conversation; you’re just postponing it.

• ‍It can restrict your ability to attract additional investors: If there isn’t a clear lead investor backing your company and building momentum, other potential investors may hesitate to come on board.

What happens if a convertible note reaches maturity?

Here is what commonly happens when a convertible note reaches maturity.

• ‍Maturity extension: The most common solution is to extend the note’s maturity. This gives the founders additional time to raise a priced round. In exchange, investors may renegotiate certain terms, such as lowering the valuation cap or increasing the discount rate to compensate for the added risk.

• ‍Immediate conversion to equity: Investors may convert their notes into equity without a new funding round. In these cases, the conversion terms are often renegotiated, typically resulting in a lower valuation and a higher ownership stake for the noteholders.

• ‍Demanding repayment: While legally possible, forcing repayment is uncommon. If the company cannot repay the debt, this action could push it into insolvency. This is an outcome that generally benefits neither the founders nor the investors.

Under what scenarios will a convertible note convert?

It will either automatically convert at the next successful 'qualified' financing round or, optionally, at times, investors can choose to convert at a non 'qualified' financing round. Very commonly there is a 'Conversion trigger' which stipulates the minimum gross proceeds of the financing round, to trigger automatic conversion.

What are the important things to consider while using convertible notes?

Investors should remember that raising capital through convertible notes later in a company’s lifecycle may prompt skepticism. It can indicate the company failed to attract a standard-priced funding round when market valuations are usually clearer and more routine.

Founders should carefully consider a few critical factors:

• ‍Equity dilution risk: A wide gap between the convertible note's valuation cap and the priced round's valuation can lead to greater-than-expected ownership loss for founders and future investors.

• ‍Cash flow pressure from interest: Notes demanding cash interest payments, rather than equity conversion, drain resources needed for hiring, development, or growth.

• ‍Cap table complexity: Multiple notes with varying terms create a messy ownership structure, raising legal hurdles that may repel future investors.

How do convertible notes impact the cap table?

Typically, they do not appear in a company's Cap table simply because they have not converted, and most cap tables do not account for what happens in the event of a conversion.

This is because it will require the company to construct a scenario analysis to see if the next 'theoretical' financing round will trigger an automatic conversion. However, even despite attempting to build the cap table, there is a wide array of possibilities on the liquidation preference, investment amounts and how existing ownership changes.

These factors usually deter companies from trying. Unless, there is an upcoming financing round and all current/prospective stakeholders are interested in the cap table's outcome.

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