Key Takeaways

  • A convertible promissory note is a loan that can convert into equity, often used in early-stage startup financing.
  • These notes delay valuation discussions until a later financing round while allowing investors to benefit from future equity.
  • Key terms include interest rate, maturity, conversion trigger events, discount rates, valuation caps, and prepayment clauses.
  • Both investors and startups face risks, such as potential loss of priority (for investors) or excessive dilution (for companies).
  • Legal clarity is crucial—especially in defining conversion mechanisms, rights upon default, and treatment during stock splits or sales.

Convertible Promissory Note: What is it?

A convertible promissory note is a form of debt that converts to equity when either a certain event has occurred or a certain date has passed. The conversion from debt to equity will depend on the agreement between the person or company that has issued the note and the investor.

The two parts of a convertible promissory note are the promissory note and the equity conversion rights. 

A typical promissory note will have the principal, the interest rate, the maturity date, how the note will be secured (usually by assets of the company), and details of what will happen if there is a default.

The equity conversion will include an explanation of the event that will trigger the conversion. It should also include the formula used in converting the debt to equity, the type of equity the debt will be converted into (common stock or preferred stock), and any additional equity rights that the investor will gain from converting the debt, such as voting rights or dividends. 

For example: BB Financing is a financial services company that requires $250,000 in funding to achieve its one-year goals. BB Financing attracts two investors, John and Barry, by offering them convertible promissory notes of $125,000 each. John and Barry's notes will automatically convert once BB Financing raises $1.5 million in equity. Seven months later, BB Financing receives $1.5 million in financing. The two convertible promissory notes are then converted into equity, effectively canceling the notes.

How Convertible Promissory Notes Compare to SAFEs

While both convertible promissory notes and SAFEs (Simple Agreements for Future Equity) offer paths to equity, there are key differences:

Feature Convertible Promissory Note SAFE
Legal Form Debt Contractual right to future equity
Maturity Date Yes Typically none
Interest Rate Yes No
Repayment Obligation Possible if not converted No repayment
Simplicity Moderate legal complexity More standardized and simpler
Dilution Protection Tools Discount, Valuation Cap Discount, Valuation Cap

Convertible promissory notes may be preferred when both parties want debt protections or clearer timelines for conversion.

 

Why Use a Convertible Promissory Note?

There are a few reasons to use convertible promissory notes when trying to raise capital for your business. 

  • They are the easiest and quickest way to work with investors. There is very little legal work to be done when using a convertible promissory note. Many experienced investors don't want to involve expensive legal counsel in most convertible debt investments. A term sheet for a convertible promissory note deal might be two or three pages, while a Series A preferred stock financing deal could be between eight and 10 pages.
  • It allows companies to raise capital without having to put a valuation on their business right away. Often, if a company has just started or has not even launched yet, valuing the business is nearly impossible. In convertible debt financing, the investment is made without placing an explicit valuation on the startup.

When to Use a Convertible Promissory Note

Convertible promissory notes are especially useful in several scenarios:

  • Pre-valuation Stage Startups: When it's too early to determine a fair company valuation.
  • Bridge Financing: To fund operations between equity rounds or during a transition.
  • Founder Loans: When founders inject personal funds and want the option to convert those loans to equity.
  • Deferred Equity Negotiations: To delay the complexity and cost of equity negotiations until more capital is raised.

These notes allow flexibility and speed, making them a practical option for early-stage fundraising without sacrificing long-term strategy.

Risks of Convertible Promissory Notes for Investors

Investors are often taking a very large risk by financing a company that is just starting up. Later investors usually have better bargaining power, especially if the company really needs financing. This means that initial investors usually don't get as good a deal and are unable to renegotiate the terms of the note.

Usually, initial investors aren't well-compensated for all of the investments that they put into the early stages of the company. Besides the monetary investment, they are giving client contact details, making introductions with suppliers, and adding credibility to the company with their name.

If the value of the company grows because of the investor's efforts, the investor is actually increasing the price they will pay for their own equity in the company. 

Investors in convertible promissory notes are creditors to the company until the notes convert to shares. This means that if the company goes bankrupt, they may lose their investment entirely. If the company is sold before the note converts, then the investor is only entitled to their principal and interest.

Risks of Convertible Promissory Notes for Companies

Convertible notes are great for a company if its value increases from the time of the initial financing to the time they issue their first preferred stock. If this doesn't happen or the company actually decreases in value, the initial investors who bought convertible promissory notes could end up owning more equity in the company than the company anticipated.

The equity purchased by the investor usually has a liquidation preference, so in addition to getting greater equity in the company at the expense of the business owner, investors probably also get preference over the owners to the cash of the company in the case of a sale, dissolution, or closing up of the company. 

Another risk of convertible promissory notes to a company is if a convertible note is not converted into equity before maturity, investors could demand that the note is repaid with principal and interest. This could potentially put the company into bankruptcy. 

Conversion Triggers and Their Implications

The terms that define when and how a convertible promissory note converts into equity are critical. Common triggers include:

  • Qualified Financing: Automatic conversion upon the company raising a specified minimum amount in a future equity round.
  • Maturity Date: If no financing occurs, the note may convert automatically on the maturity date, or the investor may choose to be repaid.
  • Optional Conversion by Investor: Investors may reserve the right to convert at any time, giving them flexibility but creating uncertainty for founders.
  • Change of Control: A sale or merger can trigger conversion, often at a predetermined rate.

The implications of each trigger should be fully understood, as they affect ownership structure, control, and exit planning.

What Is Included in a Convertible Promissory Note Contract?

  • Principal and Interest — How much will be given to the company and what will their interest rate be?
  • Maturity — This outlines exactly when the company will repay the principal and interest if it has not been converted into equity.
  • Conversion — This should outline exactly what will occur in order for the note to be converted into equity. This can be if the company raises a certain amount of financing or can be set to convert at the investors' discretion. It can also be decided that the note will convert at the time of maturity.
  • Mechanics of Conversion — This section outlines how the investor will convert the note into equity. It usually requires the investor to hand over the note in order to receive company shares.
  • Payment — This outlines how the repayment will work. It is not in the interest of the investor to have the company pay the money back quickly and without much interest accrued, so that is usually mentioned in this part of the note.
  • Representations and Warranties of Lender — This section is required by securities laws and explains exactly what the investor is allowed to do with their equity as well as with the note before it converts to equity.
  • General Provisions — This final section is where any other issues that either party wants to address should be placed. This includes the jurisdiction of any disputes that may arise and explanations about how to make amendments to the agreement.

Prepayment Provisions and Impact

While standard promissory notes often allow prepayment, convertible notes typically require negotiated prepayment terms. Founders may seek the ability to repay early to avoid equity dilution, while investors might resist prepayment if they expect a better return via conversion. Prepayment clauses may include:

  • No Prepayment Without Consent: Requiring lender approval before early repayment.
  • Penalties for Prepayment: Imposing fees to discourage repayment before maturity.
  • Automatic Conversion on Prepayment: Treating prepayment as a trigger for equity conversion at a favorable rate for the investor.

Clear language around prepayment can help avoid disputes and preserve each party’s expectations.

Key Financial Terms in Convertible Promissory Notes

Convertible promissory notes often include additional financial mechanisms beyond the core terms. These influence the conversion value and potential equity stake for the investor:

  • Valuation Cap: Sets a maximum valuation at which the note will convert into equity, protecting early investors from excessive dilution if the company’s value spikes.
  • Discount Rate: Provides a percentage discount on the share price during conversion, offering early investors a financial incentive for their risk.
  • Interest Accrual: Interest usually accrues until conversion and is often included in the total amount converted into equity.
  • Conversion Price Formula: May be based on a fixed price, a future financing round’s price, or a predetermined formula.

These terms are highly negotiable and should be carefully reviewed and clearly stated in the agreement.

What Is Preferred Stock?

Preferred stock is a class of equity ownership that offers certain advantages over common stock. Investors holding preferred shares typically receive dividends before common shareholders and may have enhanced rights, such as the ability to veto specific corporate actions. These rights make preferred stock a more secure and potentially influential investment, especially in startup or high-risk ventures.

What Happens if the Maturity Date Passes Without Additional Financing?

If a convertible promissory note is structured to convert upon the occurrence of future financing but that financing does not materialize by the maturity date, the company has a few potential options. It can repay the investor in full, including any accrued interest; request an extension of the maturity date; convert the note into preferred stock; or convert it into common stock. The chosen course of action often depends on the specific terms of the note and the negotiation between the company and the investor.

What Is a Convertible Debenture?

A convertible debenture is a type of convertible debt instrument similar to a promissory note but typically secured by collateral. This means the borrowing company must pledge assets as security in case of nonpayment. Convertible debentures often include additional investor protections and are commonly used in more formal or substantial financing arrangements, offering a greater level of security for the investor compared to unsecured convertible notes.

What Is a SAFE?

A SAFE, or Simple Agreement for Future Equity, is an investment contract that allows investors to receive equity in a company at a future date, typically triggered by a valuation event such as a financing round. SAFEs differ from convertible promissory notes in several ways: they do not accrue interest, lack a maturity date, and are generally simpler to draft and execute. However, they may not offer the same protections as debt instruments and can exclude holders from dividends or other rights afforded to common shareholders.

Is a Convertible Promissory Note Always Considered a Security?

Not always. While many securities attorneys treat convertible promissory notes as securities—since they often represent an investment of money with expected profits derived from the efforts of others—this classification can vary. If the note is never converted into equity and is treated purely as a loan, it may not be considered a security under federal or state law. Nonetheless, due to the complexity and potential implications, companies should consult legal counsel to ensure compliance with applicable securities regulations.

Frequently Asked Questions

1. What’s the difference between a convertible promissory note and a SAFE? A convertible promissory note is a debt instrument with repayment and interest, while a SAFE is a contract for future equity with no repayment or interest obligation.

2. How does a valuation cap benefit the investor? A valuation cap protects early investors by ensuring their conversion happens at a lower, predetermined company valuation, giving them more equity for their investment.

3. Can a convertible note be repaid instead of converted? Yes. If conversion does not occur by the maturity date and the note terms allow it, the investor may demand repayment of principal plus interest.

4. What happens if the startup is acquired before conversion? Depending on the note terms, the investor may convert to equity before the acquisition or receive a cash payout. Some notes specify conversion or repayment conditions in these scenarios.

5. Are convertible notes subject to securities regulations? Yes. Convertible promissory notes are typically considered securities and must comply with applicable federal and state securities laws. Legal counsel should always be consulted.

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