What Is a Convertible Note?
A convertible note is one solution to a dilemma that commonly arises with early-stage startups in search of seed funding.
The dilemma is this: the startup needs seed investors to give it money so that it can grow its business and make more money. But since the startup is still in its early stages and isn’t quite ready for a valuation, it’s not practical to offer equity right now in exchange for the funding it needs right now. So, if not straight-up equity, what can this hypothetical startup offer an angel investor or seed investor in exchange for their much-needed money?
One possible answer is a convertible note, a short-term debt instrument that gets around the tricky question of valuation in a way that can benefit all parties involved. Rather than give the startup money in exchange for equity, the investor loans the startup money and receives a note that can later be converted into an amount of equity in the company. (The specific amount of equity the investor receives is calculated according to a predetermined formula.) See! The name actually makes sense.
Convertible notes aren’t the only solution to some of the funding questions that arise with early-stage startups, but they can make a lot of sense for startup founders and investors alike. In this guide, we’ll walk you through the basics of convertible notes and discuss how they compare to other early-stage funding options, like SAFEs.
- What is a convertible note?
- How does a convertible note work?
- What happens if a convertible note reaches its maturity date?
- The pros and cons of convertible notes
- Convertible notes vs. SAFEs: Which is better?
What is a convertible note?
Convertible notes, also known as convertible promissory notes, are short-term debt instruments oftentimes used in seed financing and venture capital.
Like many other debt instruments, convertible notes come with an interest rate, as well as a maturity date at which the lender/investor is entitled to full repayment, or an extension of, their loan.
But investors generally aren’t interested in treating convertible notes as they would a typical loan, in which they receive their money back plus any interest that has accrued. This is because a convertible note offers something they perceive as potentially even more valuable: the ability to get repaid with shares of the company.
The specific number of shares the convertible noteholder will be entitled to—as well as the milestone that triggers the note’s conversion into equity—is typically determined at the time the note is issued. Oftentimes, the note’s conversion coincides with a future fundraising round (such as Series A financing) in which the company’s valuation is determined.
Debt or equity? A convertible note is a bit of both
If you’re confused about whether convertible notes are debt or equity, well, it helps to think of them as a unique combination of the two.
Convertible notes are like debt in the following ways:
- They’re structured as loans—which means they have some of the stuff a typical loan would have. Convertible notes have an interest rate, which determines the amount that must be paid back in addition to the principal amount. (If all goes according to plan, this amount will be paid in equity rather than dollars.) Convertible notes also have a maturity date, at which time the noteholder is entitled to repayment, or an extension of, the note.
- Convertible noteholders don’t have certain benefits that certain equity holders enjoy, such as an ownership stake in the company and voting rights. This is a typical distinction between debt and equity investment. One thing debt holders usually do have that’s nice is priority in line for payments in the event of a sale or liquidation of the company.
- Outstanding convertible notes are generally accounted for as debt liabilities on a company’s balance sheet. After a note is converted into equity, it should be accounted for as equity.
But convertible notes are also like equity in one very essential way: They’re an investment in the company’s future growth.
Again, convertible noteholders aren’t in this game because they want to get their dollars back plus a bit of interest. Convertible notes are a means investors use to fund a company sooner, in the hopes that their early-stage investment will pay off in a ton of future equity later down the line. If all goes according to plan, the investor will end up not with a note but with equity, such as shares of preferred stock.
So, a convertible note is, in a way, both debt and equity. As with a caterpillar’s evolution to a butterfly, its transformation from one to the other takes some time.
How does a convertible note work?
Aside from an interest rate and maturity date, a typical convertible note includes some important provisions that determine how it will ultimately convert into equity—and what happens if (gulp) it never does.
We’ve already established that a convertible noteholder is entitled to a certain amount of equity upon the occurrence of a conversion event. We’ve also established that the amount of this equity is based on, not only the investor’s principal amount, but also any interest accrued prior to the conversion event. But how, exactly, is the amount of equity owed to the investor determined?
To answer this question, it’s helpful to know that most convertible notes come with a valuation cap. A valuation cap is used to determine the maximum share price a convertible noteholder will pay at the next conversion event, such as a fundraising round. (Uncapped convertible notes do exist, though they’re less common.)
With this in mind, let’s take a look at an example of how the valuation cap works.
How a convertible note’s valuation cap works
Say a startup is given a post-money valuation of $20 million in its Series A round—which seems about average these days, according to 2021 data from Crunchbase. This does not mean that an investor’s convertible note will convert at a valuation of $20 million. If the valuation cap on the convertible note is, say, $10 million, then the investor’s shares convert at the lower valuation.
The lower the valuation cap, the better the deal for the investor. Looking at the above example, let’s say an investor puts in a $1 million investment. Since they locked in a valuation cap of $10 million, their note would convert into a 10% share of the company ($1 million is 10% of $10 million). If another investor comes along without a convertible note and invests the same $1 million during the Series A round, they’d only get a 5% share of the company ($1 million is 5% of the post-money valuation of $20 million).
But that’s not the whole story—a discount rate may also affect the math on the conversion price.
How a convertible note’s discount rate works
In some cases, a convertible note will specify a discount rate instead of (or in tandem with) a valuation cap.
Otherwise known as a “bonus rate,” this discount rate gives the convertible noteholder a discount on the price paid by other investors when the note converts into company stock. So, if a convertible note investor invests $1 million into a company with a 50% discount rate, their $1 million would convert at a price that’s half-off what other investors might get. Using the example of the company above with a $20-million valuation, the investor would end up with a 10% share of the company post-conversion. So, in this case, a 50% discount rate amounts to the same investor benefit as a valuation cap of $10 million.
It’s not likely that a convertible note investor will benefit from a low valuation cap and a discount rate. In most cases, the investor will receive one or the other. If language regarding both a valuation cap and a discount rate is written into the convertible note terms, there will usually be something in there that says which applies in a specific outcome. It’s far more common that the lower of the two (i.e. the one more favorable to the investor) will apply.
What happens if a convertible note reaches its maturity date?
A convertible note may be a convertible debt instrument, but it is still a debt instrument, after all. So we need to focus a bit on some of the debt instrument-y stuff about it—including that pesky maturity date. What happens, you may be wondering, if the maturity date on a convertible note arrives before the next equity financing round? Does the promise of future equity just go up in smoke for the investor?
As a rule, early-stage companies don’t issue convertible notes with the intention of hanging their investors out to dry. They definitely want the note to convert into equity and make good on the seed investment, so in some sense a convertible note can act as additional motivation to ensure that the next round of financing arrives before the maturity date.
Does this always happen? Not necessarily. But well-run startup companies should be prepared for the eventuality of a maturity date coming due prior to the round of funding that would convert the note into equity.
And by “prepared,” we mean “something should probably be written into the convertible note terms about this.” In some cases, the investor may be granted the right to extend the maturity date. Or, they may receive some other benefit to make up for the lack of conversion event, such as a lower valuation cap or a cash payout that’s worth more than the equity they stood to receive.
What if the conversion event never occurs?
It’s worth mentioning that, in some cases, the conversion event may not happen at all. Perhaps, for example, the startup’s existing stockholders have voted to be acquired by a larger company. What happens to a convertible note in these types of instances should also be agreed upon ahead of time, and it may involve the investor receiving a cash payout for the principal amount they invested plus any interest accrued over time.
An acquisition and cash payout obviously isn’t the most ideal outcome for the investor, but there are worse outcomes yet. There’s always the possibility of the company struggling to manage its cash flow, failing to attract new investors, and having to default on a convertible note. In these unhappy cases, the seed investment can basically go up in smoke and the investor may not have much recourse. This should serve to highlight that convertible notes are not inherently secure investments—as with many things in the wild world of venture capital, the risk of failure is oftentimes commensurate with the potential payoff of success.
The pros and cons of convertible notes
So, yes, convertible notes have their advantages and disadvantages. Let’s review some pertinent examples of pros and cons for startup founders:
Advantages of convertible notes
- Convertible notes can make it easier to raise capital. One of the main reasons convertible notes exist is to make raising capital a bit less cumbersome for early-stage companies. Equity financing at a company’s earliest stages can be difficult at best and impractical at worst, especially if the company doesn’t have money to cover all the lawyers necessary in a typical round of financing.
- Convertible notes don’t require a company valuation. This is related to the first point, in the sense that convertible notes are generally a faster and easier way to finance an early stage company than going through, say, a seed round that requires a difficult-to-pin-down valuation.
Disadvantages of convertible notes
- You have to pay interest to the convertible noteholder. One sort of nice thing about convertible notes is that you don’t have to give equity to the investor to get cash in return—er, at least not right away. That bill will eventually come due, though, and when it does, it will come due with interest in the form of (potentially) even more equity.
- Convertible notes aren’t always the least complex option. Yes, convertible notes exist in part because they reduce the need for heavy lawyering in some respects. But relying on a lot of convertible notes for early-stage funding can muddy up your cap table in the short- to mid-term, and there may be a simpler option available: the SAFE.
Convertible notes vs. SAFEs: Which is better?
A Simple Agreement for Equity Funding (otherwise known as a SAFE) is an agreement that an early-stage startup makes with an investor. Like a convertible note, a SAFE is a type of convertible security. Also like a convertible note, it aims to solve the pesky issue of a startup not having a formal valuation nor shares to issue to the investor.
But SAFEs and convertible notes are different in several key respects. For one, the money invested in a SAFE doesn’t come with an interest rate or a loan maturity date; instead, it automatically converts into shares when the criteria are met for the next equity financing round. The startup accelerator Y Combinator launched the SAFE in 2013 partly in response to startups struggling with some of the implications of convertible notes—specifically, the need for a lawyer to negotiate individual provisions. Since SAFEs involve only a few inputs and the math is standardized, they’re basically plug-and-play.
That’s not to say that SAFEs are right for every startup—or that all SAFEs are alike. You can read more about the ins and outs of pre-money and post-money SAFEs in our guide on the topic. Or, better yet, set up a call with Pulley to chat about your options and which solution makes the most sense for your cap table.