Convertible Note: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
A convertible note is a security, typically used by angel investors or seed investors, that is a short-term loan, to provide seed capital for a business. 6 min read updated on January 01, 2024
What is a Convertible Note?
A convertible note is a security instrument, typically used by an angel investor or a seed investor, that takes the form of a short-term loan, either secured or unsecured, to provide seed capital for a business. The convertible nature of the note allows the debt to be converted into equity in the company (typically in the form of preferred stock) at some specified future event, often in connection with the company’s valuation in a later round of funding. Convertible notes are often preferred by seed investors as a way to fund a new company while avoiding the need to value the company in its earliest stages when accurate valuation may be difficult.
Should a company fail before the note is converted, the investor’s interest in the convertible note has priority over an equity interest (stock) and, generally speaking, is first in line for repayment – behind any secured debt in the company.
Conditions Associated with Convertible Notes
While the balance of a convertible note is converted to equity in the company at a specific time, there are usually special terms and conditions associated with that conversion, such as caps, discounts and minimum funding requirements. Caps and discounts act as additional rewards for the high risk that investors take in funding new ventures.
Understanding Convertible Note Caps
Convertible note caps (aka valuation caps) set a maximum price at which the loan will convert from debt to equity. Convertible caps act as a reward to seed investors for investing early on without creating valuation problems for the company. Here’s an example of how that advantage works, starting with these assumptions:
Seed investor’s investment with a valuation cap of $4,000,000 with no discount.
Series A company pre-money valuation: $12,000,000.
Per-share price paid by Series A investors: $10.00
The valuation cap is adjusted on a per share basis for convertible note holders using a formula like this:
$12,000,000 (pre money valuation) / $4,000,000 = $3.00 per share.
A $10,000 investment secured by a convertible note at this point would grant the note holder 3,000 shares at $3 per share, as compared to a Series A round investor, who would pay $10 per share, resulting in only 1,000 shares on a $10,000 investment. Due to the Series A price of $10 per share, the convertible note holder’s $10,000 investment is valued at $30,000.
Understanding Convertible Note Discount Rates
This is another method of rewarding angel investors by providing them additional compensation for the higher risk they are taking. Discounts provide a percentage reduction in the cost per share to be paid by the convertible note holder in relation to later Series A investors. For example, assume that a seed investor is holding a convertible note with a 20% discount rate. Assume also a Series A valuation of $10 per share. Now, consider two investors, the first investing $10,000 secured by a convertible note with a 20% discount rate provision, the second a Series A investor investing $10,000 without a convertible note.
Investor with convertible note:
Per-share price applying convertible note discount: $10.00/.20 = $8.00 per share.
$10,000/$8 = 1,250 shares.
Series A Investor without convertible note:
$10,000/$10 = 1,000 shares
Interest Rates on Convertible Notes
Convertible notes are loans and, therefore, come with an interest rate (typically between 4% and 8%) that determines how much interest accrues on the initial loan amount prior to the note’s conversion to equity. While a traditional loan requires that interest be paid in cash, a convertible note holder will receive greater equity in the company in the form additional stock shares up the note’s conversion. Here's an example:
Angel investor loans $2,000 to a startup secured by a convertible note with a 5% interest rate.
Startup receives Series A investment one year later.
Angel investor earns $100 in interest for a total investment value of $2,100.
Series A valuation = $10 per share.
Upon conversion, the angel investor receives 210 shares ($2,100/$10 per share = 210 shares.)
Maturity Date on Convertible Notes
Because a convertible note is a loan, it also has a "due date" which is known as a maturity date. The maturity date is the date upon which the note is due and payable by the company to the note holder. If the startup has not been able to raise money from another source, or if it has have become profitable and no longer requires additional financing, the note converts to equity shares in the company. Here's how that would work:
Angel investor invests $2,000 into a startup.
Convertible note has a maturity date of 24 months.
The discount rate on the note is 20 percent.
The interest rate is set at 5 percent.
Shares are valued at $1 after 24 months.
Angel investor is entitled to $2,500 worth of shares for an investment of $2,000.
Here's what the formula looks like:
$2,000 x 1.2 (discount rate) = $2,400 (after the discount)
5 percent interest for 2 years ($2,000 x 0.05) = $100.
Total value to angel investor: $2,400 + 100 = $2,500 in stock.
It should be noted here that investors rarely call in a convertible note on its maturity date, opting instead to extend the time to a future date or milestone. The reason is that calling in the note on its maturity date may result in significant financial damage or even bankruptcy to the company, dooming any chance for the company to succeed and the investor to profit.
Advantages to Convertible Notes
There are a number of significant advantages to using convertible notes for initial funding instead of issuing shares of common stock. Primarily, convertible notes avoid:
Dilution: It is often difficult to determine the value of a brand new startup and, therefore,issuing shares of common stock to raise initial investment funds can result in significant dilution of the company’s value. Using a convertible note can prevent this problem.
Tax issues: If the company founder or any co-founders accept stock for a small purchase price at the time of incorporation, and investors pay a higher price for their shares at or near the same time, it is possible that the IRS will look at the difference in value as a form of compensation paid to the founders and assign a higher value to the founders’ shares, resulting in those shares being taxed as ordinary income. The use of convertible notes to raise seed funds avoids this potential problem.
Investor control: One of the pitfalls of issuing stock in return for an investment in your company is your loss of company control to the shareholders. For example, stockholders may request a board seat or veto rights. Convertible notes, on the other hand, rarely include language that would jeopardize founder control of the company.
Speed and Cost of Funding: Convertible notes are often far easier to negotiate than other types of financing. Unlike more sophisticated investments that require early valuations and extensive legal involvement, obtaining funding through a convertible note may only require a simple promissory note and an agreeable investor. The result is quick securing of your funds without incurring unnecessary legal fees.
When to Use Convertible Notes
You need help from an angel investor because your concept is ready to go and you need funding immediately.
Your startup company does not have a current valuation and you believe delaying that valuation is beneficial.
You are confident that you will be able to convert the note to equity within the stated time period.
The cap and discount provisions of your convertible note are attractive to angel investors.
When to Avoid Convertible Notes
Your company already has a fair market value, therefore negating the advantages of convertible notes.
You do not expect to have the required equity available to convert the note by the maturity date.
The cap or discount is not attractive enough to secure funds from an angel investor.
Your prospective investor demands unreasonable concessions in return for funding.
Frequently Asked Questions
- What are conversion triggers?
Conversion triggers are those events, specifically set forth in the note, that trigger the conversion of the note to equity in the company. The most common is the maturity date. Another example is the “next qualified round,” meaning that an upcoming round of funding will be sufficient to allow conversion of the note without causing financial harm to the company.
- What is a convertible promissory note?
Technically speaking, a promissory note is the actual document that lays out the terms of the agreement between the investor and the founder of the company. It states in writing the note’s interest rate, maturity date and all other necessary terms and provisions of the agreement.
- What is convertible note funding?
Convertible note funding refers to the seedfunding received by the company from the angel investor that is secured by the convertible note, which confers rights to the angel investor to convert the note to equity in the company at a future time.
- What is a convertible debt?
Debt that is exchanged for cash or, more commonly, stock in the company, is called convertible debt.Following the conversion to equity, the angel investor may sell his shares on the open market or continue to hold onto the shares. In addition, the company may have the right to repurchase the shares, if so provided for in the terms of the note.