What is a Convertible Note?

A convertible note refers to a short-term debt instrument (security) that can be converted into equity (ownership portion in a company). Convertible notes are often used by seed investors who invest in startups. They are structured as loans to convert it to an equity stake of the company in the future.

As far as the process of funding is concerned, the debt is automatically converted to a known amount of equity shares (common or preferred) at the time of closing the Series A financing round.

To put it simpler, after investors initially loaned capital to a new company (startup) and it’s grown enough to repay the debt, investors wish to get a predetermined amount of preferred stock instead of receiving their money with interest. It is part of the startup’s original preferred stock financing based on the terms of the convertible note.

Main Advantage of Convertible Notes

In essence, issuing convertible notes does not compel the issuer and investors to come up with a value of the company (future company) at the time when they might not be able to properly perform valuation, i.e., when the company is just an idea that needs implementation.

A valuation will be typically conducted during the Series A financing round, given a sufficient amount of data about the company.

Terms of Convertible Notes

When assessing a convertible note to define its value, the following aspects should be taken into account:

1. Discount Rate:

The discount rate is the percentage by which the price per share of the convertible note is discounted when the note is converted into equity.

2. Valuation Cap:

The valuation cap is the maximum valuation at which the note can be converted into equity. If the company is valued at a higher amount during the Series A financing round, the investor will convert the note at the valuation cap.

3. Interest Rate:

The interest rate is the rate at which the convertible note accrues interest. The interest rate is typically low, ranging from 2% to 8%.

4. Maturity Date:

The maturity date is the date when the note is due and payable. If the company has not raised a Series A financing round by the maturity date, the note will be due and payable.

5. Conversion Trigger:

The conversion trigger is the event that triggers the automatic conversion of the note into equity. The most common conversion trigger is the closing of a Series A financing round.

6. Conversion Price:

The conversion price is the price per share at which the note is converted into equity. The conversion price is typically set at a discount to the price per share of the Series A financing round.