What are convertible notes?
A convertible note is a form of short-term debt that converts into equity (stock) once you raise your first significant round of equity capital, like a Series A.
- The convertible note investor lends money to the venture.
- The investor is repaid in equity, rather than cash.
Why convertible notes?
Raising capital with convertible notes is quick, straightforward, and inexpensive.
Kicking the valuation can down the road
Startups are notoriously hard to value (see our Business Valuation Services page). With minimal track record, assets, and visibility into the future to discuss, negotiations between the entrepreneur and investors drag on, all too often without resolution.
With convertible notes:
- Valuation is determined in a subsequent financing – when more information is available.
- The convertible noteholder is simply guaranteed a discount to the price paid by investors in the next equity round – at the time of the equity financing, the convertible noteholder effectively enjoys an automatic step-up in valuation. The convertible noteholder’s risk, therefore, is limited.
Streamlining the process
In addition to deferring the valuation discussion, convertible note financings tend to be speedy and uncomplicated.
- There are far fewer terms than for equity raises.
- Less time and, importantly, lower legal fees are involved.
- Before valuation has been established, there are likely no tax consequences for stock options grantees.
- Founders typically maintain full decision-making powers, and board seats are not given up.
How do convertible notes work?
Each convertible note offering carries terms stipulating the rights of the investors and the issuer. Three main categories of terms are:
- Conversion discount
- Valuation cap
- Interest rate
The terms are first set forth for negotiation purposes in the non-binding convertible note term sheet, and later in the final convertible note agreement.
The conversion discount, expressed as a percentage, is the discount received by convertible noteholders upon conversion into equity. At the time of the equity capital raise, convertible noteholders effectively spend the entire value of their debt to buy equity shares. (Normally, they buy convertible preferred equity shares, but that’s a topic for another discussion.)
The number of shares received is simply the total value of the debt divided by the price per share. The price per share is that paid by the new investors – the equity investors – less the conversion discount.
Here’s an example:
- The convertible noteholders own $500,000 worth of convertible notes at the time of the equity offering.
- The convertible note agreement stipulates a 20% conversion discount.
- The equity offering is priced at $10 per share.
- The convertible note holders effectively buy equity at $8 per share ($10 less the 20% conversion discount).
- The convertible note holders receive 62,500 shares upon conversion ($500,000 ÷ $8).
- Without the conversion discount, the convertible note holders would receive only 50,000 shares ($500,000 ÷ $10).
The conversion discount effectively ensures a return superior to that of the equity investors, rewarding the convertible noteholders for the greater risk assumed when getting in at an earlier stage.
The valuation cap establishes a minimum percentage ownership by convertible noteholders after the equity offering. Viewed another way, the valuation cap places an upper bound on the price paid by the convertible noteholders for the equity.
Here’s an example:
- $500,000 in convertible notes are issued, with an $8 million valuation cap.
- An equity capital raise is completed at a $12 million valuation (post-money).
- The convertible noteholders convert into equity at a maximum valuation of $8 million – the valuation cap – rather than at the $10 million actual valuation at the time of the equity offering.
- The convertible noteholders hold 6.3% of the equity after the offering ($500,000 ÷ $8 million).
- Without the valuation cap, the convertible note holders would hold only 4.2% of the equity after the offering ($500,000 ÷ $12 million).
Like the conversion discount, the valuation cap helps reward the convertible noteholders for the greater risk assumed when getting in at an earlier stage than the equity investors.
The interest rate stipulates how much the total value of the convertible notes increases with the passage of time.
Upon conversion, the convertible noteholders’ value equals the original amount invested plus accrued interest, as determined by the interest rate. Interest is not paid out as accrued; it is added to the principal – the value – of the convertible notes. The increase in value, as indicated by the interest rate, is typically accrued on a simple, not a compounded, basis.
Here’s an example:
- $500,000 in convertible notes are issued, with a 0.5% monthly (6.0% annual) interest rate.
- An equity investment round is completed 18 months after the convertible notes round.
- Convertible noteholders convert $545,000 worth of debt into equity ($500,000 x 0.5%/month x 9 months).
The interest rate specifies how much convertible noteholders are compensated for the time elapsed until the subsequent financing occurs.
The accompanying exhibit provides an illustration of how convertible notes work:
When are convertible notes a good option?
Convertible notes can be just the ticket to securing capital at the seed stage of your venture’s development – before you’re ready for that Series A to really get things rolling. A convertible note offering can bring in much-needed cash quickly, straightforwardly, and inexpensively. Cash to get to proof of concept. Cash to reel in critical talent. Cash to secure a letter of intent from a critical customer. Cash to get to where you can confidently look a VC in the eye and say, “Don’t miss the boat on this one.”