Convertible Note Interest Rate: Everything You Need to Know
The convertible note interest rate can range from 2 to 8 percent. However, it stays most often in the 5 to 6 percent range.3 min read
Updated October 28, 2020:
The convertible note interest rate can range from 2 to 8 percent. However, it stays most often in the 5 to 6 percent range. There are instances when the interest rate can range from 2 to 4 percent annually.
Overview of Convertible Note Interest Rate
Convertible note interest technically qualifies the note as a debt instrument. If an investor attempts to increase the interest rate, the other party should ask for a lower discount or price cap.
The purpose of the interest rate when dealing with convertible note financing is to make sure investors receive a minimum return. In this way, companies that cannot raise additional funds that result in the notes automatically converting into equity will give investors back their money and a minimal rate of return at maturity.
- The interest rate should not be less than the federal rate. If this were to happen, the note could be deemed as containing an original issue discount. You can find this in IRC Section 1272(a).
- Usury laws provide a maximum limit set for the annual interest rate.
- Lower rates of interest tend to be available on the coasts and internationally. Higher rates tend to be in the middle of the country.
- Convertible note interest accrues until either the note converts into equity or is paid out.
- Once a convertible note makes the conversion to equity, the interest typically converts into preferred stock rather than being paid out.
Information About Convertible Notes
When an investor loans money to a startup, instead of receiving payment in the form of principal plus interest, they will receive equity in the company. The convertible note is a short-term debt that will convert into equity in conjunction with a future financing round.
A convertible note is similar to a promissory note for any other types of loans. The two share similar terms, such as "maturity date" and "interest." Convertible notes are often referred to as "bridge notes." This is because the investors were involved in a prior round and are in negotiations with the company on another round. The financing of the notes bridges the company's finances until the round closes.
Convertible notes are advantageous because they do not force either the issuer or investors to determine the value of the company. In some cases, the company may only be an idea. The valuation is usually determined during the Series A financing when more data are available to base a valuation.
The main purpose of investing in convertible notes is not about receiving a large monetary return. However, the notes do earn investors' interest in the 2 to 8 percent range.
An investor will usually convert the note's principal plus interest into equity. This generally occurs when an investor, such as a venture capitalist, makes an investment of a certain amount. When convertible notes convert into equity, it is with a conversion discount or a price cap.
Convertible Note Terms
Several key points to keep in mind when evaluating a convertible note include the:
- Discount rate: This rate represents the valuation discount received during the subsequent financing round. The investors have the right to convert the loan amount, plus interest, at a reduced price (based on percentage) at a Series A financing round. It serves as compensation for the risk of early investment.
- Valuation cap: This is an added bonus for bearing the risk early. It caps the price when notes convert into equity. In a way, it also provides investors holding convertible notes an equity-like situation if the company is successful from the start.
- Interest rate: For investors who lend money to a company, the convertible notes will most likely accrue interest. Instead of being paid cash, the interest accrues to the principal that was invested. In turn, this increases the number of shares that will be issued upon conversion. Note that the interest rate of convertible notes indicates the amount of interest accrued to the investor before the conversion of the notes into equity or its repayment as cash when called.
- Maturity date: This date signifies when the note is due. At that time, the company will need to repay it.
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