What Is a Convertible Note? Examples & How It Works
This article is part of a larger series on Business Financing.
A convertible note is a financial document that allows a business to receive cash in exchange for equity in the company. This is a short-term agreement typically made with an angel investor, venture capitalist, or other type of private investor. It’s similar to a loan because it allows a business to receive more funding.
However, unlike a loan that has to be repaid in cash, a convertible note is satisfied by giving the investor ownership interest in the company. Ownership interest usually comes in the form of preferred shares of the company, and the exact time frames and calculation methods are determined by the specific terms in the note.
How a Convertible Note Works
Since a convertible note allows an investor to receive equity at a later date, it’s in their interest to fund a business that will succeed. The amount of equity that will be awarded to the investor will be outlined in the terms of the note, which can include the following:
- Interest rate: This is similar to an interest rate on a traditional loan. In exchange for providing cash to your business, an investor can require a minimum return on the amount invested. A 10% interest rate on an investment of $100,000 allows the investor to convert it to $110,000 after one year.
- Discount rate: This allows investors to purchase shares at a reduced price when compared to their face value. For example, if the shares in your startup business are valued at $1 per share, a 10% discount rate would allow the investor to purchase them at 90 cents per share.
- Valuation cap: This places a maximum dollar amount the company can be valued for the purposes of the convertible note. As demonstrated in the examples below, it’s beneficial to the investor because it helps avoid interest from being diluted and can allow them to obtain more shares and equity if your startup business performs well.
- Maturity date: This is the specified date for when a startup receives a valuation and the investor can convert the note into equity.
Examples of Convertible Note Calculations
With the convertible note terms mentioned above, you can calculate the cost of funding, which is how much the convertible note will cost you once you receive a business valuation. In the examples, we assume a $100,000 convertible note on a business that receives a valuation of $2 million, or $1 per share, after one year.
Term | Interest Rate | Discount Rate | Valuation Cap | Cost of Funding |
|---|---|---|---|---|
Interest Only | 10% | None | None | $110,000 |
Discount Only | None | 10% | None | $111,111 |
Cap Only | None | None | $1 million | $200,000 |
Interest & Cap | 10% | None | $1 million | $220,000 |
Discount & Cap | None | 10% | $1 million | $222,222 |
Interest, Discount & Cap | 10% | 10% | $1 million | $222,222 |
Click on the terms below to learn how to calculate the cost of funding based on the different terms.
10% of the initial investment of $100,000 is $10,000. Adding the two gives a cost of funding of $110,000.
Take $100,000 and divide it by 90 cents to get a cost of funding of $111,111. We arrive here by taking the per-share cost of $1 and factoring in the 10% discount rate that allows the investor to purchase shares at 90 cents.
Take the valuation cap of $1 million and divide it by the current valuation of $2 million to arrive at a cost of 50 cents per share. Since this is half the cost of the valuation of $1 per share, we take the $100,000 convertible note and divide it by 50 cents to arrive at a cost of funding of $200,000.
Take the valuation cap of $1 million and divide it by the current valuation of $2 million to arrive at a cost of 50 cents per share. Since this is half the cost of the valuation of $1 per share, we take the $100,000 convertible note and divide it by 50 cents to arrive at $200,000. Then add the 10% interest rate to arrive at a cost of funding of $220,000.
Take the valuation cap of $1 million and divide it by the current valuation of $2 million to arrive at a cost of 50 cents per share. With a 10% discount, that figure becomes 45 cents per share. Now take the $100,000 convertible note and divide it by 45 cents to arrive at a cost of funding of $222,222.
Take the valuation cap of $1 million and divide it by the current valuation of $2 million to arrive at a cost of 50 cents per share. Since this is half the cost of the valuation of $1 per share, we take the $100,000 convertible note and divide it by 50 cents to arrive at $200,000. The 10% interest rate gives us $20,000, which is added to the previously calculated discount and cap figure of $222,222 to give us a final cost of funding of $242,222.
Who a Convertible Note Is Right For
A convertible note might be right for you if you’re a startup looking to quickly obtain financing so that you can focus more on developing your product or service. It can also be a good choice if you prefer to repay investors in equity rather than cash. Here are some other examples of when a convertible note could be a good option:
- You’re a low-revenue company: Convertible notes typically do not require repayment for at least one to two years, so you can focus more on using the funds to develop your product or service, with less pressure on generating enough revenue to satisfy monthly payments on a traditional loan.
- You want to be the first to market: Funding obtained from a convertible note can be done much faster than a traditional loan. You can use a convertible note if you have an innovative product or service and need cash to develop it quickly to gain market share.
- You don’t have a business valuation: A business valuation largely determines how much capital you can raise in funding rounds, such as Series A, B, and C. Valuations are determined by several factors such as a market risk analysis and track record of your company’s management. If there isn’t enough information to arrive at a valuation, investors can provide you with funding via a convertible note in exchange for equity.
- You want to develop a minimum viable product (MVP): Developing an MVP can be one method that can be used as a proof of concept to gain confidence from more investors. However, if you’re a first-time business owner with no track record of success, you may have trouble finding an investor.
- You want to prioritize product development in the short term: While it’ll eventually be necessary to generate revenue for yourself and other stakeholders in the company, this can be a good choice if you believe that focusing on product development in the short term will yield a substantially greater amount of returns in the long run.
- You’re already planning for your seed or Series A funding rounds: Plan ahead and speak with other investors about the possibility of funding once your company hits certain milestones. If your company does not raise a funding round before the convertible note’s maturity date, you could be required to repay the note if the note holder does not agree to give you an extension.
How To Get a Convertible Note
Angel investors often issue convertible notes to startups they believe have potential for growth. You can find an investor and get angel funding by looking at your network of personal and business contacts.
There are also various online directories that list angel investors.
- AngelList: Founded in 2010, the company has funded over 12,000 startups and has over $13.5 billion in assets supported.
- StartEngine: A popular equity crowdfunding source for businesses based in the U.S.
- FundersClub: Since its founding in 2012, the company has helped over 350+ startups with a total of over $180 million in funding.
- Angel Capital Association: An organization that allows you to find angel groups and platforms by region.
Pros & Cons of Convertible Notes
| PROS | CONS |
|---|---|
| No monthly loan payments | You lose ownership interest in your company |
| Terms can be negotiated with individual investors | Complex terms can be difficult to understand |
| Can receive funding more quickly than a traditional loan | Can be difficult to find investors |
| Investors have a vested interest in your success | Short-term agreement that often requires a subsequent successful funding round to satisfy terms of the note |
Alternatives To a Convertible Note
A convertible note can be a good way to get funding for your startup, but there are other ways to get cash that don’t require you to give up equity in your company. Here are some alternative funding options:
- Startup business loans: These loans cater to newer businesses that might have difficulty getting loans from banks. They have more flexible requirements for revenue, credit score, and time in business. You can also read our guide on how to get a small business loan.
- Small business grants: Grants can provide your business with cash with no repayment required. However, this can be a difficult source of funding to obtain due to limited availability and competition from other businesses.
- Funding from friends and family: Asking for funds from friends and family can give you more flexibility for interest rates, repayment methods, and other loan terms. They may even be willing to gift you some funds.
Two additional options similar to a convertible note are a Simple Agreement for Future Equity (SAFE) and Keep It Simple Security (KISS). A SAFE is different from a convertible note because it has no maturity date, so it’s possible it may never convert to equity. A debt version of a KISS has an interest rate and maturity date, while the equity version of KISS has neither.
Bottom Line
Convertible notes can give you a source of funding quickly if getting a traditional loan isn’t possible. These notes require no monthly repayments, so you can place more of a focus on developing the product rather than earning revenue in the short term. However, finding an angel investor, venture capitalist, or other private investor to issue a convertible note can be difficult. Before choosing a convertible note, you should consider alternative funding options for your business and ensure you’re OK with giving up equity in your company.
