A convertible note is a short-term debt that has an interest or discount rate, a valuation cap, and a maturity date. Investors use convertible notes to invest in startups in the early stages of development. Investors can choose to convert convertible notes into preferred shares on a specific date or event.
What Is a Convertible Note?
A convertible note, which is a convertible debt, rewards investors with interest and discount rates and increases the purchasing power of each dollar when they convert the debt to equity. It also protects investors from the risk of dilution; if a company were to raise money in another funding round, for example. Investors and businesses negotiate convertible notes, so there are no standards.
When a startup raises capital from angel investors or other early-stage funding sources like accelerators, it uses a convertible note to do so. Investors receive the convertible note, which gives them the option to convert the debt into equity at maturity. Startups can repay investors in cash on the maturity date or trigger conversion with another round of funding.
Who a Convertible Note Is Right For
Companies use convertible notes to raise money from investors, like angel investors. They rely on this short-term debt because it enables them to finance growth without immediate equity dilution or regular debt payments. Depending on a company’s stage of development, convertible notes may be used to develop a minimal viable product, grow a team, reach new customers, or as a temporary cash-flow solution between rounds of funding.
Situations in which investors and startups use convertible notes include:
- Financing growth: Startups rely on pre-seed and seed investments in the form of convertible notes to finance growth initiatives like marketing, hiring, and product development.
- Developing a minimum viable product: Startups sometimes use convertible notes to build a minimum viable product. This funding is more difficult to get for first-time founders, but investors finance these ventures for entrepreneurs with previous success.
- Avoiding a valuation: Raising money from friends and family or outside investors for equity requires them to determine a startup valuation. With limited data, this usually isn’t viable. To take part in equity while avoiding a valuation, investors issue convertible notes to startups.
- Bridging two funding rounds: This is the least common use of convertible notes in the startup ecosystem. Founders who are raising capital may delay venture capital funding for due diligence or to negotiate better terms. While this happens, they may raise smaller amounts of funding to cover expenses.
There are other reasons startups may raise convertible notes, but in most cases, they need funding to keep growing. Investors may also prefer a note because it gives them some protection from downside risk, but in most cases, there is limited value to recover from startups that fail at these early stages. Either way, startups and investors who use notes should understand the impact of different terms.
“A convertible note financing is most useful at the stage that the company expects aggressive growth and can benefit from postponing valuation. For investors, convertible notes allow them to secure yield with the added upside of future equity at a discounted price. It also widens the pool of potential investors because both debt and equity investors can participate in the same fundraising round.”
– Christine Chang, CEO of 6th Avenue Capital
Convertible Note Terms
Convertible notes have an interest rate, discount rate, valuation cap, and a maturity date. Investors need not use all the terms and typically select either an interest or discount rate and may forgo a valuation cap. The maturity date is also commonly triggered by a subsequent funding event, like series A, B, C, and D funding instead of a specific date because the startup timeline is too unpredictable.
Terms of convertible notes include:
Investors receive a premium on the capital they invest in the form of interest. Interest rates vary, but 10% to 20% is a common range that investors add to the note’s principal. In this case, an investor who provides $100,000 with a convertible note can convert for $110,000 to $120,000 worth of equity after one year.
The discount rate offers investors an opportunity to purchase equity at a reduced price, typically 10% to 20% below face value. A startup that receives a $1 million valuation, with 1 million shares, has a per-share value of $1. Without a discount, a $100,000 convertible note converts to 100,000 shares. But with a 10% discount, it converts to 111,111 shares because the share price drops to 90 cents at conversion.
With a valuation cap, investors and founders negotiate a maximum dollar amount they will assign to the value of the company. A startup that receives a $2 million valuation with 2 million outstanding shares has a per-share value of $1. A convertible note for $100,000 with a $1 million valuation cap would convert at only 50 cents per share, granting an investor 200,000 shares. This happens because investors use the valuation cap rather than the actual valuation of the company.
Convertible notes with set maturity dates sometimes include clauses for extensions because the timeline for startups is unpredictable. Most notes mature at the next financing event, which for startups in the seed stage is outside investment from a venture capital firm. This is the point when a startup receives a valuation and early investors receive equity.
“In the $4 million of angel funding I have done using convertible notes, I use a 10% interest rate with a discount to the Series A round (20%), and a fair market cap depending on traction. It is easy to understand and investors have been OK with investing in my companies because they know how to make money using that fair formula.”
– David Metzler, CEO of CBDCapitalGroup
Convertible Note Examples
It can be difficult for entrepreneurs to conceptualize the long-term impact of a convertible note on their business. The best way to illustrate many of these concepts is with an example of the same startup receiving different terms on a note. For example, let’s consider a startup that raises a $100,000 note with no maturity date and receives a valuation of $2 million, or $1 per share, in one year.
Five Convertible Note Examples
Cost of Funding
Interest and Cap
Discount and Cap
Interest, Discount, and Cap
Convertible note examples with different terms include:
- Only interest: A convertible note with only an interest rate functions most like short-term business financing. This is one of the most predictable examples of convertible debt because the only uncertainty is the timeline for repayment.
- Only discount: The most predictable convertible note is one with only a discount rate. Although a discount rate is slightly more expensive than an equivalent interest rate and is difficult to understand, the time horizon is much more certain. Like with all the other notes, entrepreneurs won’t know the total cost until they receive a valuation.
- Interest and cap: The valuation cap included in the note doubles the total cost of funding for entrepreneurs. This happens because the note is converted at the valuation cap, rather than the actual valuation.
- Discount and cap: Having both a discount and valuation cap increases the cost by more than double because the calculation applies the discount rate after the valuation cap. This results in a greater discount per share for investors who convert and a higher overall cost for founders.
- Interest, discount, and cap: The final example shows that convertible notes with interest and discount rates in addition to a valuation cap are the most expensive for entrepreneurs. This should not come as a surprise, but entrepreneurs should keep it in mind when negotiating terms.
There are no standard terms between investors and entrepreneurs that use convertible notes. The variability of this arrangement is one of its largest drawbacks. Seasoned entrepreneurs and investors recommend getting advice from someone who has been through the process to avoid any long-term issues. Negotiating and agreeing on terms can feel like a quick process, but it impacts the company for several years.
“Both as an entrepreneur and angel investor, straight equity and convertible notes with clear maturity dates, caps, and discounts are the only financing instruments I have used. My strong advice for entrepreneurs is threefold: negotiate a sufficiently high cap, aim for two to three years maturity as opposed to 18 months, and focus on clear-cut and iron-clad conversion terms.”
Convertible Note Alternatives
Entrepreneurs who are seeking funding for their business can use convertible notes. However, there are other versions with more benefits and added flexibility, like a Simple Agreement for Future Equity (SAFE) and a Keep It Simple Security (KISS). Besides those, SBA microloans and grants are also options. These alternatives to notes are also not exclusive, so founders can raise money from multiple sources.
Alternatives to convertible notes include:
Y Combinator developed the Simple Agreement for Future Equity (SAFE) to capture the flexibility of convertible notes without the debt component. A SAFE does not include a maturity date or an interest rate, resulting in a simple agreement for investors and startups. Startups that use a SAFE do so because it doesn’t place a time limit on the startup’s development.
A KISS, or Keep It Simple Security, is like a convertible note but has a debt and an equity version. It contains many additional clauses and triggers related to the sale of the company, minimum funding rounds, and transfer rights. While it’s a great option for a contract that spells out every scenario, entrepreneurs should ensure they understand the potential impact of every detail.
While convertible notes are a common form of financing for startups, SBA microloans are available for short-term financing up to $50,000. The average SBA microloan is under $15,000 but for many entrepreneurs, that money is far less costly than equity, and a microloan can fund the early stages of development.
Entrepreneurs can apply for business grant opportunities from local, state, and national governments and nonprofits. Grant sizes vary and qualification requirements depend on the mission and location of the business and the entrepreneur’s background. This field is competitive, but so is raising money from angel investors, so for many entrepreneurs, it’s worth a shot.
Pros & Cons of Convertible Notes
Convertible notes don’t have any ongoing costs and offer startups and investors the flexibility to customize funding. However, it can be difficult to find investors and the notes can be more expensive than other forms of short-term debt financing. Setting up terms with an investor is also challenging, but if done right, notes have the potential to align the interests of both parties.
Pros of Convertible Notes
Pros of convertible notes include:
- No ongoing costs: Convertible notes inject cash but don’t require monthly payments, so funds can go to building and operating the business. Convertible notes add to current cash without the monthly payments of regular debt that increase the operating costs of the business.
- Flexible terms: The flexibility around the terms of a convertible note can be a major benefit to entrepreneurs and investors. Selecting interest rates, discount rates, maturity dates, and triggers enable both parties to create a customized agreement that suits them.
- Aligned investor and startup interests: Investors who issue convertible notes have an incentive to see the company succeed. The note is usually redeemable at the next funding round, which means the company is growing quickly. Getting there is difficult, but many angel investors act as advisers in this process.
“Convertible notes make sense for early-stage startups. In this stage, it is difficult to establish or agree on a valuation, so a note postpones that valuation event.”
– Ted Chan, CEO of CareDash.com
Cons of Convertible Notes
Cons of convertible notes include:
- Difficult to find investors: Finding angel investors isn’t difficult, but securing funding from them can be a challenge for entrepreneurs. It doesn’t get easier with accelerators and incubators, which have admission rates that are lower than most business schools.
- More complex than other debt: Estimating the impact of discount rates, interest rates, maturity dates, and valuation caps keeps financial engineers busy. Most entrepreneurs don’t have the experience to navigate convertible note terms and should rely on advisers to fill that gap.
- Dilutes equity: The cost of equity is more difficult to estimate than debt costs. Equity agreements are long-lasting and result in permanent dilution of the ownership of founders. Founders have difficulty estimating the costs of convertible notes because there is no company valuation.
“One thing to stay away from is a ‘death spiral.’ This reduces the conversion price based on later rounds of financing. Although this might protect the investor, it causes more dilution and is problematic for the company.”
– James Cassel, Founder and Chairman of Cassel Salpeter & Co
Convertible Note Frequently Asked Questions (FAQs)
Startups and early-stage investors use convertible notes to provide funding. These instruments can be complex, and every funding situation will raise new questions that this article does not answer. Below are some answers to frequently asked questions about convertible notes, and readers can post additional questions on the Fit Small Business forum.
Can a convertible note be paid back?
In theory, a startup can repay a convertible note; however, investors guard against early repayment by retaining the right to deny it. Their reasoning is that successful startups may repay the note, but if a startup is successful, the equity is more valuable.
What happens when a convertible note matures?
A convertible note with a maturity date functions similar to other short-term debt, except the entire payment is made on that date. When a note matures, the startup must repay the principal to the investor with interest. The only exception to this rule is if the investor converts to equity before the maturity date.
Is a convertible note debt or equity?
Convertible notes are a short-term debt that converts into equity. Investors can request startups to repay the debt on a maturity date with interest or convert at a subsequent fundraising event. Most notes automatically convert into equity when a startup raises a round of series A funding.
There are many examples of startups raising capital with convertible notes with a lot of variations in terms. Each financing scenario is different, and notes offer both parties the option to negotiate a set repayment date and interest rate like traditional debt financing. They also offer investors the option to convert debt into equity in the form of preferred shares at a premium. This flexibility is a driving force behind why startups use notes.