Key Takeaways

  • Standard convertible note terms include crucial features like valuation caps, discounts, maturity dates, and conversion triggers.
  • Maturity dates and interest accrual protect investors while incentivizing timely conversion.
  • Cap tables can be significantly impacted by how and when notes convert.
  • Legal considerations, including default triggers and pro rata rights, must be carefully negotiated and documented.
  • Notes can include optional conversion provisions, early repayment clauses, or MFN (most favored nation) terms for flexibility.

Standard convertible note terms are parameters for a specific form of short-term business debt. A convertible note will convert into equity at a future date, meaning that the investor loans money to an entrepreneur and receives equity in the company rather than payments on the principal plus interest.

What are Convertible Notes?

Convertible notes offer a major advantage because they don't force the investors or issuer to determine a company's value. In fact, the company may only be an idea or in its earliest stages of development when an investor chooses to jump onboard.

So-called seed-stage investments are often structured as convertible loans or straight equity. These are investment deals ranging from about $100,000 to $1.3 million. With straight equity, a business issues investor stock shares and designates them as “Series Seed,” making sure to include enhanced rights. If an investor prefers, they can invest in a convertible note where the security isn't issued until the next round of financing.

By nature, standard convertible notes have added investment risks specifically related to a company's preliminary stages. Because of this fact, the notes may contain extra clauses such as caps and discounts.

Here are a few parameters and convertible note terms to be aware of:

  • Class security: Will the note be converted into ordinary or preferred stock?
  • Conversion triggers: Convertible notes are meant to be converted in the future, so you must consider the expiration or maturity date at which point the note-holder must convert the outstanding loan amount, ask for the money back, or have the company extend the maturity date.
  • Note interest: A convertible note is a form of debt, so it accumulates interest over a set time; this interest rate is typically 4 to 8 percent, and it is converted during the next financing round.
  • Security: Is the convertible note secure and, if so, are the company's assets being used as collateral?
  • Warrants: This is another form of investment incentive which enables the investor to purchase extra shares.
  • Valuation cap: This places a maximum price that the loan will convert into equity, which rewards seed investors for the excess risk they're willing to take on.
  • Discount rate: This calculates how much is owed in compensation for the extra investment risk.
  • Next equity financing: The next round of financing for the convertible note; in most cases, the conversion is automatic.
  • No next financing: This occurs when the conversion is allowed by raising the next equity financing fails.

Essentially, standard convertible note terms protect both businesses and investors, providing a quick, inexpensive, simple means of raising funds.

Common Use Cases for Convertible Notes

Convertible notes are frequently used during a startup’s early financing rounds, especially when valuation is difficult to determine. They offer a flexible alternative to priced equity rounds. Common scenarios include:

  • Seed-stage funding: Early investors contribute capital before a company is formally valued.
  • Bridge rounds: Companies use notes to raise interim funding between larger equity rounds.
  • Accelerator or incubator investments: Startups accepted into programs often receive initial capital via convertible notes.
  • Founder's friends and family investments: Convertible notes can simplify legal complexity and costs for informal early-stage fundraising.

This approach allows startups to defer valuation discussions until a subsequent funding round, while investors benefit from early participation incentives.

Advantages of Standard Convertible Note Terms

Seed investors will often negotiate a discount in the next equity round for their price per share, which rewards early investors. Having a conversion discount term attached to the standard convertible note can help attract seed investors from the earliest stage. These discounts vary, ranging anywhere from 10 to 74 percent.

One of the biggest advantages of standard convertible notes is the conversion cap. Conversion caps allow parties to put off negotiations until the next round of financing. While some risk exists for the seed investor, namely that the valuation is often much higher and more expensive for the investor, the discount can offer certain protection against inflation.

For example, let's say a company has a $1 million convertible loan without a discount or cap. It goes on to raise $5 million at a pre-money valuation of $20 million. This scenario results in a per-price share of $1. That note would convert into one-million shares divided by $1 per share. However, if the convertible note had a $5 million cap, the shares would convert at a $0.50 per-share rate instead of $1 per share.

Legal Considerations in Convertible Note Agreements

When drafting convertible notes, certain legal terms carry significant implications for both investors and issuers. Important provisions include:

  • Maturity date: Typically set 12–24 months out, triggering repayment or conversion.
  • Automatic vs. optional conversion: Notes may convert automatically upon a qualified financing or require mutual consent.
  • Default clauses: Some notes include provisions allowing acceleration of repayment in the event of default.
  • Pro rata rights: Investors may secure rights to participate in future rounds to maintain ownership percentage.
  • Subordination clauses: These determine the note’s priority in the event of liquidation or insolvency.

Clear documentation is critical. Terms should align with corporate bylaws and investor expectations, and legal counsel is strongly advised.

Conversion Calculation Methods

Calculating standard convertible notes typically involves one of three methods:

  • Pre-money method
  • Fixed percentage method
  • Dollars invested method

The pre-money method is set at $8 million and is best for founders because they end up with 60 percent. Founders don't benefit as much from the fixed percentage method, which is also referred to as the post-money method. With the fixed percentage method, founders end up with 55.7 percent. To achieve balance, some investors and business owners opt for the dollars invested method, but it doesn't hold the obvious benefits to either party.

Cap Table Impact and Dilution

Understanding how convertible notes affect your capitalization table (cap table) is crucial. The timing and terms of conversion directly influence founder equity and investor ownership.

  • Valuation cap effects: If the company’s value exceeds the cap, early investors convert at a lower share price, resulting in more equity and greater dilution to founders.
  • Discount effects: A discount allows investors to purchase equity at a reduced price, which also increases their ownership stake upon conversion.
  • Multiple notes: Stacking several notes with different terms can compound dilution. It’s important to model scenarios with all outstanding instruments to assess the impact.

Sophisticated startups often use cap table management software to project outcomes and keep investors informed.

Optional Terms and Variations in Convertible Notes

Beyond the standard terms, convertible notes can include optional provisions tailored to investor or issuer preferences:

  • Most Favored Nation (MFN) clauses: These allow early investors to adopt more favorable terms granted in later notes.
  • Early repayment rights: Some notes include a call option allowing the issuer to repay the debt (plus interest) before conversion.
  • Interest repayment flexibility: Notes may allow accrued interest to convert into equity or be paid out in cash.
  • Qualified financing definitions: Parties may negotiate what constitutes a “qualified” round that triggers automatic conversion, typically based on a minimum fundraising threshold.

These variations add flexibility but also require careful legal review to avoid unintended outcomes.

Frequently Asked Questions

  1. What happens if a convertible note reaches maturity without a conversion event?
    The noteholder may choose to convert manually, request repayment with interest, or agree to an extension, depending on the note’s terms.
  2. Do convertible notes dilute founder equity?
    Yes, once notes convert into equity, they increase the total share count, which reduces the percentage ownership of existing shareholders.
  3. Can a convertible note have both a cap and a discount?
    Yes, and most notes include both. The conversion typically occurs using the more favorable term to the investor—whichever results in a lower price per share.
  4. How are convertible notes taxed?
    Generally, convertible notes are treated as debt for tax purposes until conversion. Interest may be taxed as income, and gains on conversion may trigger capital gains tax depending on timing and structure.
  5. What’s the difference between a SAFE and a convertible note?
    A SAFE (Simple Agreement for Future Equity) is not a debt instrument and doesn’t accrue interest or have a maturity date, unlike convertible notes. SAFEs are simpler but may not offer as much investor protection.

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