The Ins-and-Outs of Convertible Notes

Ok, ok, I heard you. In this cool funding environment, many founders have been asking us a simple question: What the heck is a convertible note? And, more importantly, is a convertible note right for your financial needs?

A convertible note may be exactly what you need to stave off this slow season of funding and give your company the runway it needs to make it to later rounds and higher valuations. Here are a few more questions to answer: Are you pre-revenue? Are you waiting to open a seed investment round? Are you bootstrapped and are in need of money for acceleration?

If you answered yes to one or more of these questions, then a convertible note is right for you. To help, I outline the reasons and benefits for taking out a note, as well as break down the common characteristics of this hybrid debt-equity financing vehicle. Read on, fellow business enthusiasts!

Benefits of a Convertible Note

A convertible note is an investment vehicle most commonly used in seed rounds. The reasoning and benefits are two-fold:

1. Convertible notes push off company valuations to a later date, and many startups that do not want to establish a value at such an early stage use this as a way to delay equity valuation.
2. Some companies simply don’t want to give away equity and instead want to pay back their investors in principle and interest.

Ah, we can already hear you saying it: Principle, interest, equity? This makes no sense.

Well, that’s the beauty of a convertible note. It’s a debt instrument that can be converted to equity at a later date. Essentially, a loan is given to a company by an investor or group of investors. The loan accrues interest just like any old loan, except that instead of covering the interest payments, the company simply lets the interest accrue, increasing the amount of money owed back to the investor.

Then, when the note reaches maturity, the investor converts the total balance owed into equity, thus purchasing a portion of the company. The maturity date is usually a milestone such as a later investment round.

A Simple Example

Before I go on, let’s break it down by using a simple example. Let’s say that you take out a convertible note with an investor for $100 in principal and a 10% annual interest. An unrealistic amount, yes, but it’s a simple example, remember?

So, at day one, the investor gives your company $100, and then after one year, you owe them $110. After year two, thanks to compounding interest, you owe them $121. And then fortune shines upon you and you open a series-A investment round! Your company is valued at $20 per share. Rejoice!

However, the convertible note can now be converted to equity, and since you technically owe the investor $121, they can convert the note into 6 shares of your company. Your equity pool would thus be diluted by 6 additional shares. Or, you could pay the investor off their $121 and be done with it, keeping the equity for yourself.

Convertible Note Discount

Unfortunately, as is common in the business world, sometimes convertible notes aren’t as simple as the example above. Many times, this financing vehicle will carry a discount with it. A convertible note discount is a percentage reduction in the next qualified priced round, meaning that the investor can purchase shares of your company at a discount.

Common discounts hover around 20%, with some reaching higher. So, using the example above, if the note carried a 20% discount, the investor would be able to purchase shares at $16 instead of $20 [($20 * (1–0.20)]. At $121, this would give the investor the ability to convert the note to roughly 7.5 shares.

The idea here is that the investor is compensated for the risk of giving money to such an early stage company.

Convertible Note Cap

Now, investors who give you money in a seed round or even in an unofficial friends and family round need to be adequately compensated. Be nice — they’re funding your idea and your dream! What would you do without them?

This idea serves to preface the following: Convertible notes also often have a cap. A cap is the maximum a company can be valued. When a note reaches its maturity milestone, it converts at the lesser of the valuation at the priced round and the price cap.

Why is this important? Well, your company’s valuation is a major factor into the value of your individual shares. And if a convertible note can be converted to equity shares of your company, the lower the valuation, the more of your company you give away, and vice versa.

So, if the convertible note has a cap of $10 million, and you open a series-A investment round at a $15 million valuation, the investor can convert the note as if the value per share was based on a $10 million — and not a $15 million — valuation. Of course, if the value of your company is $8 million and the cap is set at $10 million, the lesser of the two would prevail, and the note would convert at the $8 million valuation.

Convertible Notes and Pro-Rata Rights

Sometimes a pro-rata rights clause is included with a convertible note. These rights give an investor the ability to invest in later funding rounds in order to maintain their percentage ownership in the company. Many investors of early-stage companies like to include this as a way for them to continue to invest in a company they see as having potential.

However, these rights are more uncommon in convertible notes than caps and floors. What’s more, the lead investor in a later round sometimes requests that pro-rata rights are waived.

Convertible Note Maturities and Interest

A quick note here before we conclude. It was mentioned in passing, but all convertible notes have a maturity date and an interest rate. Interest, as discussed previously, accrues on the principle and increases the amount that is converted to equity at a later date. However, it should be noted that the standard interest rate on this type of instrument is 2% here on the West Coast, and between 4–8% elsewhere.

Technically, the maturity date indicates the time when the note is due to be repaid to the investor, along with any accrued interest. However, maturity dates are usually based on milestones such as a later company valuation or investment round. If the maturity date is, in fact, a hard date, investors usually amend and extend the maturity date annually in the hopes of a later investment round. Calling on a loan at maturity when a company still hasn’t raised additional funding is counterintuitive to an investor’s goals.

Conclusion

Admittedly, after reading through the above, convertible notes seem advantageous to the investor. And they are — if the investor is willing to take on a high level of risk, that is.

And that’s where you, the founder, benefits: Risk. You’re able to receive necessary business funding in a time when your company is still proving itself. This could make or break your long-term success. So, it’s a huge benefit to you, too.

What’s more, it’s not debt per se, and it’s much better than taking out a loan. Further, it delays valuation rounds to a later date, a benefit to you. Another benefit? Convertible notes give you the option of repaying the investor in full if you want to keep the equity for yourself.