Convertible Note

A convertible note is a standard fundraising instrument for early to mid-stage companies. Whether you are a corporation or an LLC, a convertible note is often used when the company valuation is too debatable to nail down a stock (or membership interest) price. Investors thus offer the company a loan with a pre-determined interest rate, and that loan plus the interest will either convert into equity at a future scenario, or be repaid at a maturity date.

If you’re considering a convertible note round, fill out the form here and we’ll walk you through the process. We offer the completed form for a fixed fee. However, if you want us to manage the raise, that will be charged hourly.

What is a Convertible Note and why is it used in fundraising?

A Convertible Note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. It is commonly used in startup fundraising because it postpones the valuation of the company until a later round of funding, which can be advantageous for both founders and investors in the early stages of a company’s growth. It is similar to a SAFE Agreement in that valuation and conversion are postponed to a later date, however, a convertible note typically bears interest and comes with a specific date for repayment, unlike a SAFE which does not convert until a qualified financing round.

What are the key terms included in a Convertible Note?

Key terms in a Convertible Note are typically the interest rate, maturity date, conversion terms, discount rate, and a valuation cap. These terms determine how the debt will convert into equity, under what conditions, and what advantages investors will receive in the next round of funding (such as receiving a discounted price per share compared to later investors). A brief overview of these terms is as follows, though it’s important to note that as with all investment instruments, the terms can vary widely across the market:

• Interest Rate: A convertible note will usually contain an interest rate. This could be quite low, or it may be a more market rate of 8% or above. But it’s important to clarify whether the interest is simple or compounding.
• Maturity Date: Unlike a SAFE, a convertible note has a date certain at which the note must be repaid. This is much more favorable to investors, because they have a definite time horizon. Usually this is 3-4 years, but it can very widely.
• Conversion Vote: Convertible notes will vary in what requires conversion. In a company friendly note, the company has stronger control over forcing the notes to convert. In a more investor friendly note, the investor (or the investor group by a vote) may get to decide if an when they want to convert.
• Discount Rate: A typical convertible note will, like a SAFE, have a discount rate of conversion, usually this is at 80%. Meaning if there is a “qualified financing”, then the total value of the note converts into equity at 80%. So if the stock price is $1.00 per share for the qualified investors, the convertible noteholders get to purchase the each share for $0.80.
• Valuation Cap: A typical convertible note will also have a valuation cap, which is a limit on the maximum price at which the note can convert into equity. We think the most helpful way to think about this to think of the amount of the convertible note as the numerator and the valuation cap as the denominator. That means the investor will typically want a lower valuation cap (because a smaller denominator gets them a bigger percentage of the company) and the company will typically want a higher valuation cap (because a larger denominator means less dilution of the company. The right valuation cap varies widely from company to company, but is an extremely important term to negotiate properly. If the round valuation is under the valuation cap, then the discount rate is used for conversion. If the round valuation is at or exceeds the valuation cap, then the valuation cap is used.
• Security Interest: Occasionally, but not often in our experience, a convertible note will have a security interest. Meaning the loan amount is secured against some asset of the Company, usually intellectual property or some other hard asset of value.

Is a Convertible Note better than direct equity investment?

The answer is usually yes, but not always. Convertible Notes are often more advantageous than direct equity investments in early-stage startups because they allow for simpler, quicker fundraising rounds without requiring an immediate company valuation. This can be beneficial when the company’s potential is high but not yet easy to quantify. However, it is of course not suitable for all situations, and where the company and investors have a specific valuation in mind, direct equity becomes much more sensible.

How does the Convertible Note impact the ownership structure of a startup?

Upon conversion, a Convertible Note will impact the ownership structure of a startup by diluting the equity of existing shareholders. The extent of dilution depends on the terms of conversion and the valuation at the time of equity conversion. It is important for founders to understand how these instruments can affect their control and stake in the company, and it’s also important for companies to have good governing documents to regulate investor rights once conversion happens. So we highly suggest getting in touch with us before negotiating a convertible note.