What is a Convertible Note?
A convertible note is a type of short-term debt that converts into equity, typically in conjunction with a future financing round. Instead of receiving principal and interest payments, investors receive equity in the company. This financing instrument is commonly used by startups to raise capital during their early stages.
Understanding Convertible Notes
Convertible notes offer a way for startups to delay valuation negotiations until a later financing round when they might have more leverage. The debt will be converted to equity at a future date based on the terms agreed upon in the note.
How Does a Convertible Note Work?
Convertible notes function as a hybrid between debt and equity. They start as a loan to the company but are designed to convert into equity later. Key components of a convertible note include the principal amount, interest rate, discount rate, valuation cap, and maturity date.
- Principal Amount: The amount of money the investor lends to the startup.
- Interest Rate: The interest accrued on the loan amount, typically between 5-8%.
- Discount Rate: A reduction on the share price at which the note converts to equity, rewarding early investors. Common discount rates are between 10-30%.
- Valuation Cap: The maximum valuation at which the note can convert into equity, protecting early investors from excessive dilution.
- Maturity Date: The date by which the note is expected to convert into equity or be repaid.
Convertible Note Example
Suppose a startup issues a convertible note with the following terms:
- Principal Amount: $100,000
- Interest Rate: 6%
- Discount Rate: 20%
- Valuation Cap: $5 million
- Maturity Date: 18 months (about 1 and a half years)
If the startup raises a Series A round at a $10 million valuation after 12 months, the convertible note will convert into equity at a $5 million valuation cap or a 20% discount to the Series A price, whichever provides more shares to the investor.
Terms of Convertible Notes
- Conversion Trigger: Typically, the next qualifying financing round.
- Conversion Price: Determined by the discount rate or valuation cap.
- Interest Conversion: Accrued interest often converts into equity along with the principal.
- Maturity Date: The date by which the note must be converted or be repaid.
Advantages and Disadvantages
Advantages:
- Simplicity: Easier to negotiate than equity financing.
- Flexibility: Delays valuation discussions until a later round.
- Speed: Faster to close than equity deals.
- Incentives: Provides early investors with benefits like discounts and caps.
Disadvantages:
- Uncertainty: Delays the inevitable negotiation over company valuation.
- Potential Dilution: May lead to unexpected dilution for founders.
- Debt Obligation: If not converted, it must be repaid, which could strain the startup’s finances.
SAFEs vs. Convertible Notes
SAFEs (Simple Agreements for Future Equity):
- Not a debt instrument; no interest or maturity date.
- Convert into equity upon a triggering event.
- Simpler terms but may lack investor protections.
Convertible Notes:
- Debt instruments with interest and maturity dates.
- May offer more investor protection.
- Include conversion caps and discounts.
Key Considerations When Using Convertible Notes
- Maturity Date: Ensure it aligns with expected financing timelines.
- Interest Rates: Consider how accrued interest impacts the cap table.
- Valuation Caps: Balance between investor protection and founder dilution.
- Legal Counsel: Engage experienced legal advisors to draft and review terms.
Convertible Notes and Taxes
Convertible notes can have tax implications for both the issuing company and investors. Interest payments may be tax-deductible for the company. When notes convert into equity, it may trigger taxable events depending on the specific terms and timing.
FAQs
- Can a Convertible Note Be Paid Back?
Yes, if the note reaches maturity without a conversion event, the company must repay the principal and accrued interest, unless alternative terms are negotiated. - Why Do Startups Use Convertible Notes?
Startups use convertible notes to raise capital quickly and flexibly without the need to negotiate a valuation during early stages when the company’s future is uncertain. - Why Would an Investor Buy Senior Convertible Notes?
Investors may buy senior convertible notes to gain priority over other creditors in the event of liquidation, while also having the potential upside of converting to equity. - What Is a Convertible Promissory Note?
A convertible promissory note is another term for a convertible note, emphasizing its dual nature as a debt instrument that can convert into equity. - What Is a Senior Notes Offering?
A senior notes offering refers to the issuance of debt that takes priority over other unsecured or junior debt, meaning senior noteholders are paid first in the event of bankruptcy or liquidation.
Conclusion
Convertible notes are a versatile and popular financing tool for startups and investors alike, offering flexibility, speed, and a way to defer complex valuation negotiations. Understanding the terms, advantages, disadvantages, and tax implications is crucial for both parties to maximize the benefits and minimize the risks associated with convertible note financing.
