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 used to finalize a lending agreement with a nontraditional lender, typically an angel investor or a venture capitalist. The convertible note allows a business owner to receive funds in exchange for short-term debt. Unlike a business loan, where the short-term debt is repaid and satisfied, the investor in a convertible note is given the opportunity to convert the debt into preferred shares in the borrowing company on a specific date or event.
For example, a borrowing company may use a convertible note to receive $100,000 in funding from an angel investor. Rather than repay the debt in cash, the borrowing company will award shares of ownership in the company to the investor equal to the amount borrowed plus added interest. If there’s a discount rate, the investor receives a discounted cost on the purchase of shares. This award will occur either at the maturity date or at a valuation set by a future round of funding.
How a Convertible Note Works
Like a promissory note, a convertible note is used to formalize the financial agreement. It takes the form of a loan with standard repayment terms. The loan is usually short-term, with repayment within a year or two. However, unlike a promissory note where a company will repay the borrowed capital, the investor in a convertible note is repaid with equity in the company. This occurs at a set date or event, such as an additional round of funding.
An investor would choose a convertible note instead of a promissory note if they didn’t want to be repaid in capital and, instead, wanted a discounted stake in a rapidly growing company.
A convertible note contains the following:
- Interest rate: This is a premium on the amount invested. Rates will vary, but 10% to 20% is a common amount. At 10%, an investor who contributes $100,000 can convert for $110,000 after one year.
- Discount rate: This allows investors to purchase equity at a reduced price, typically 10% to 20% below face value. A startup with a $1 million valuation with 1 million shares has a per-share value of $1. A $100,000 convertible note would be 100,000 shares without a discount. With a 10% discount, the share price is reduced to 90 cents at conversion, earning the investor 111,111 shares.
- Valuation cap: This is the maximum dollar amount assigned to the value of a company. A startup valued at $2 million with 2 million shares has a per-share value of $1. A convertible note for $100,000 with a $1 million valuation cap would convert at 50 cents per share, giving the investor 200,000 shares.
- Maturity date: Most notes mature at the next financing event. This is when a startup receives a valuation and early investors receive equity. Convertible notes often have extension clauses on maturity dates because timelines for startups can be unpredictable.
Convertible Note Examples
A convertible note can have a wide range of terms and conditions. Listed below are five of the most common terms found in a convertible note. For our example, a startup business raises $100,000 with no maturity date and receives a valuation of $2 million, or $1 per share, in 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 |
Interest & Cap | 10% | None | $1 million | $220,000 |
Discount & Cap | None | 10% | $1 million | $222,222 |
Interest, Discount & Cap | 10% | 10% | $1 million | $242,222 |
In all five examples in the table, the startup business is only receiving $100,000. The cost of funding reflects how expensive it’s for the startup to use those terms. As you go down the chart, the cost of funding increases, which makes the terms more financially beneficial to the investor. This is a chart that both startup business owners and investors should keep in mind when entering negotiations for angel funding or venture capital funding negotiations.
Who a Convertible Note Is Right For
Startup business owners and investors will choose to use a convertible note when:
- Financing growth: Convertible notes allow business owners to fund growth initiatives including marketing, hiring, and product development.
- Developing a minimum viable product (MVP): An MVP is a product that’s developed enough to satisfy early investors. First-time entrepreneurs might have trouble obtaining this type of financing, but business owners with previous success can find investors if they have an MVP.
- Avoiding a valuation: This allows a startup to raise early funds by issuing convertible notes without getting a valuation.
- Bridging two funding rounds: A business delaying a venture capital round of financing might use a smaller round of financing instead. A convertible note can be used for this, although it’s the least common use for a convertible note.
Convertible Note Alternatives
Before deciding to proceed with a convertible note, it’s important to check out alternative funding options and alternative closing documents to convertible notes, then determine the best course of action for your business.
Alternative Financing Options
- Small Business Administration (SBA) Microloans: SBA microloans are available for short-term financing up to $50,000. The average microloan is less than $15,000, but the cost of getting an SBA loan may be less expensive than giving up equity in your company.
- Grants: Startup business owners can apply for grants at the federal, state, and local levels of government, as well as from nonprofits. Competition for grant money is high, but competition for angel funding and venture capital funding is also high. Grant sizes and qualifications will vary.
Alternative Closing Documents
- Simple agreement for future equity (SAFE): Created by Y Combinator, A SAFE includes the flexibility of convertible notes without the debt component. A SAFE doesn’t include a maturity date or an interest rate, making for a simple agreement without a time limit on development.
- Keep it simple security (KISS): Originally created by 500 Startups, a KISS is similar to a convertible note but includes a debt version and an equity version. It has clauses and triggers related to a company sale, minimum funding rounds, and transfer rights. Before using a KISS, consult your legal counsel to understand the document fully.
Convertible Note Pros and Cons
The pros of convertible notes include:
- No ongoing costs: Convertible notes allow you to acquire capital for your business without the monthly payments associated with small business loans. This keeps short-term cash flow strong.
- Flexible terms: Convertible notes don’t come with the rigid terms associated with loans. Terms are negotiable between the startup business owner and the investor.
- Aligned investor and startup interests: Because the investor gains equity in your company as a part of a convertible note, there is an incentive for both you and the investor to see your company succeed quickly.
The cons of convertible notes include:
- Difficult to find investors: The competition to get funding from angel investors is incredibly high, so even having a great product with rapid growth potential might not be enough to get financing.
- More complex than other debt: The rigidity of loan terms also makes them very straightforward. Money is borrowed and paid back. Trying to calculate the impact of interest rates, discount rates, valuations, and maturity dates can be complicated. Your financial advisor should be heavily involved in any convertible notes.
- Dilutes equity: You are giving up a portion of your business with a convertible note, and the value of that lost equity is hard to calculate. This can also cause problems with decision-making, with owners and investors having different ideas about the future path of a business.
Bottom Line
Convertible notes allow your startup business to raise money through angel investors or venture capitalists in exchange for equity in the company. It enables you to raise funds without taking on the monthly payments associated with a startup business loan.
Once you find an investor willing to partner with you, the steps to drafting a convertible note are more negotiable and flexible than getting a small business loan. However, convertible notes can be complicated and shouldn’t be completed without a financial advisor involved. Consider all options for startup funding before moving forward with a convertible note.
