What Is A Convertible Note? - ContractsCounsel

Jump to Section

Need help with a Convertible Note?

Post Project Now

Post Your Project (It's Free)

Get Bids to Compare

 Hire Your Lawyer

If you’re an investor or a startup, convertible notes can provide benefits to both sides. Investors, such as venture capitalists, ‘friends and family,’ and angel groups, want reassurance. A convertible note offers a low-risk investment vehicle that helps startups meet initial capital demands while satisfying investor low-risk tolerance.

In this article, we help you learn everything you need to know about convertible notes. Let’s start by looking at convertible notes explained:

Convertible Notes Explained

Convertible notes are investment instruments that are similar to short-term debts. Investors invest in convertible notes during seed financing rounds that eventually convert to equity, such as preferred stocks, until maturity or conversion. This option works well for startups that want to reward early investors.

The most significant advantage of convertible notes is that they don’t force investors to value the company beforehand. A startup’s valuation will be relatively unknown until the Series A financing round, generating more valuation data points.

This article further explains convertible notes.

How Does a Convertible Note Work?

A convertible note works by converting debt to equity upon conversion. However, the investment’s value changes based on several variables, including conversion discounts, interest rates, loan terms, and valuation caps. As a result, startups and investors may encounter a combination of all four elements.

Meet some lawyers on our platform

Terence B.

24 projects on CC
View Profile

Forest H.

31 projects on CC
View Profile

Don G.

15 projects on CC
View Profile

Paul S.

5 projects on CC
View Profile

Key Terms to Know in Convertible Notes

Convertible notes contain legal and financial language that describe the terms and conditions . While they’re similar to other contracts, they have vital provisions that make them unique as an investment vehicle. Not understanding them can lead to unintended consequences in the future.

The key terms to know when working with convertible notes include the following:

Term 1: Conversion Discount

  • Risk : Convertible notes carry more risk in early financing rounds.
  • Reward : Conversion discounts reward investors for waiting to convert debt to equity.
  • Time : Longer investments equate to better discount rates.

Term 2: Interest Rate

  • Like a loan : Convertible noteholders should receive interest on the principal investment.
  • Events : The convertible note accrues interest after issuance and until conversion or repayment.
  • Flexibility : Upon conversion, investors can convert interest to additional equity.

Term 3: Loan Term

  • Position : Loan terms should offer startups enough time to raise equity.
  • In general : Typically, loan terms last between one and two years.
  • Optional : Investors can wait to convert shares if the startup doesn’t raise enough money.
  • Planning : Issue loan terms with unform maturity dates when dealing with numerous investors.

Term 4: Valuation Cap

  • Early compensation : Valuation caps reward investors for risks during early investment rounds.
  • Simple : Startups can offer valuation caps in conjunction with conversion discounts or as a standalone feature.
  • Better outcomes : Valuation caps can potentially lead to more significant investor ownership percentages.

As you can see, convertible notes offer incredible flexibility to the startup while making the investment more attractive to investors. A real-world example can help you understand how convertible notes work better.

Let’s take a look at the following scenario:

  • Startup A issues a convertible note to investors
  • Startup A sets the conversion discount at 25 percent
  • Startup A puts the valuation cap at $10 million
  • During a Series A round, the startup only receives a $5m valuation
  • Investor convertible notes convert at the 25 percent discount since the valuation cap was not met
  • If the startup raised over the $10 million, then shares would convert at the valuation cap

In the preceding example, the convertible note offered the investor an “either-or” option after the Series A investment round. You can negotiate and structure your convertible notes to include these provisions as well. However, some startups only wish to offer a convertible note cap or a discount.

Goods and Bads of Convertible Notes

Convertible notes have advantages and disadvantages. While they offer a tremendous investing opportunity to investors, they also have their drawbacks as well. Regardless of your position, consider the pros and cons of convertible notes.

Here are the good aspects of convertible notes:

  • Good 1. Low risk : Since convertible notes are loans, investors and startups can avoid incorrect valuation issues. This situation is perfect when the initial valuation is unknown.
  • Good 2. Pre-valuation : Investors can move toward ownership based on pre-valuation values. They can potentially receive a much bigger reward than investors coming in during later rounds.
  • Good 3: Voting power : Convertible noteholders don’t have voting rights. The startup is free to operate without managerial control from noteholders.
  • Good 4. Simple : Convertible notes are structured simply. Most initial financing rounds become complicated through other vehicles, whereas convertible notes generally don’t.
  • Good 5. Fixed income : Investors are generally offered a fixed income with convertible notes. While they will eventually become equity, investors view the reassurance of a convertible note as attractive.

Now, here are the bad aspects of convertible notes:

  • Bad 1: Bankruptcy risk : The startup could go bankrupt, which would also include your convertible note.
  • Bad 2: Debt : Startups and incubators want to raise equity versus debt. Convertible notes are debt, which carries a risk from the beginning.
  • Bad 3: Control absence : Since investors don’t have voting rights, they may not feel comfortable investing large sums of money.
  • Bad 4. Uncertainty : Investors have trouble assessing how long they should hold out before converting to equity. If they allow too much time to pass, they lose their investment.
  • Bad 5. Lack of clarity : Another risk investors face is that startups may fail to meet repayment terms. If they can’t raise sufficient equity, they won’t have enough money to repay the convertible note.

The benefits and disadvantages of convertible notes depend upon the perspective of the startup and investor. What is profitable for one said becomes a loss for another. You should always seek legal advice from convertible note lawyers if you have questions to avoid making mistakes. This strategy ensures that you’re always putting profitability and stakeholders first.

Check out this article to learn more about the implications of convertible notes.

Get Free Bids to Compare

Leverage our network of lawyers, request free bids, and find the right lawyer for the job.

Get Bids Now

Convertible Notes vs. Equity

The most significant difference between convertible notes vs. equity is that convertible notes are a form of debt that may eventually becomes equity. Equity typically presents in the form of a stock purchase agreement or SAFE note, or simple agreement for future equity. SAFE notes give investors the right to purchase shares of preferred stock shares during a future financing round.

When To Use a Convertible Note?

Startups issue convertible notes during their first investment requests. Seed investors, such as venture capitalists and angel investors , utilize convertible notes during accelerator investments. Startups and investors can prioritize debts by issuing senior convertible notes to ensure a fast payback.

You can also use a convertible note to avoid the burden of equity transfers. Rather than owing money to investors, the startup can repay them through preferred equity or senior convertible notes. As such, they no longer need to waste excessive amounts of time, energy, and money using convertible notes as an investment vehicle.

Get Help with Your Convertible Notes

The drafting and negotiation of convertible notes is challenging. Instead of leaving your next investment to chance, work with investments lawyers to help you navigate the legal issues surrounding them. Doing so can only strengthen your legal rights while ensuring that you are forging ahead practically. Connect with a legal professional in your state today to learn more about your options.

How ContractsCounsel Works
Hiring a lawyer on ContractsCounsel is easy, transparent and affordable.
1. Post a Free Project
Complete our 4-step process to provide info on what you need done.
2. Get Bids to Review
Receive flat-fee bids from lawyers in our marketplace to compare.
3. Start Your Project
Securely pay to start working with the lawyer you select.

Meet some of our Lawyers

ContractsCounsel verified
Managing Member
38 years practicing
Free Consultation

I have been practicing law for 35 years. In addition to my law degree, I hold an MBA. I've created six companies, currently act as outside counsel to another 12, and have been an advisor to more than 500 startups and entrepreneurs.

ContractsCounsel verified
Business Contract Attorney & Arbitrator
21 years practicing
Free Consultation

I am a licensed and active Business Attorney, with over 20 years of diverse legal and business experience. I specialize in contract review, drafting, negotiations, ecommerce business transactions, breach of contract issues, contract dispute and arbitration. I am licensed to practice in New York and Connecticut. I am a FINRA and NCDS Arbitrator. My experience includes serving as General Counsel to small businesses. I negotiate, draft and review a wide array of commercial contracts; provide business strategy and employment advice and assist in the sale of businesses entities. I work extensively with various kinds of contracts. In reviewing agreements, I conduct risk analysis of contract and interpret the terms and conditions so that clients understand exactly what their obligations are under the agreement and are protected as much as the law requires. I am detailed and thorough in my review and drafting of agreements. Additionally, I advise clients on how to limit their liability and lower their contractual risk. I specialize in breach of contract issues and arbitration. I have been a Hearing Officer, presiding over cases and rendering written decisions; a Civil Court Arbitrator presiding over cases in contract law, commercial law, etc., a Judicial Clerk in Civil Court; a Vice President at an Investment Bank and an Attorney at top AML law firms.

ContractsCounsel verified
Attorney-at-law and Certified Public Accountant
25 years practicing
Free Consultation

Carlos Colón-Machargo is a fully bilingual (English-Spanish) attorney-at-law and Certified Public Accountant (CPA) with over twenty years of experience. His major areas of practice include labor and employment law; business law; corporate, contract and tax law; and estate planning. He is currently admitted to practice law in Georgia, Florida, the District of Columbia and Puerto Rico and currently licensed as a CPA in Florida. He received a Master of Laws from the Georgetown University Law Center in 1997, where he concentrated in Labor and Employment Law (LL. M. in Labor and Employment Law) and a Juris Doctor, cum laude, from the Inter American University.

ContractsCounsel verified
10 years practicing
Free Consultation

Graduate of Georgetown Law (J.D. and LL.M in Taxation) Injury Claims Adjuster before law school for top insurer Eight plus years of legal experience Past roles: Associate at premier boutique law firm in the DC metro area Policy Associate at a large academic and research institution Solo Practice Areas of Expertise: Contracts Business Formation Trusts and Estates Demand Letters Entertainment Transactions

ContractsCounsel verified
18 years practicing
Free Consultation

As a business law attorney serving Coral Springs, Parkland, and Broward County, FL, Matthew has been recognized as “AV” rated, which is the highest rating an attorney can achieve through Martindale’s Peer Review system. Year after year Matthew is listed in the “Legal Leaders” publication as a top-rated attorney in South Florida in the areas of litigation, commercial litigation, and real estate. Matthew is also a graduate and instructor of the Kaufman Foundation’s FastTrac NewVenture Program, presented by the Broward County Office of Economic and Small Business Development.

ContractsCounsel verified
Managing Partner
6 years practicing
Free Consultation

John Benemerito is the Founder and Managing Partner of Benemerito Attorneys at Law. Admitted to practice in New York and New Jersey, John represents small business owners and startups in the areas of Business and Securities Law. John received his Bachelors Degree at John Jay College of Criminal Justice where he majored in Criminal Justice. Afterwards, he attended New York Law School where he focused his studies on Corporate and Securities Law. John comes from a family of entrepreneurs. From as far back as he can remember he was always involved in his family’s numerous businesses. At the age of fifteen, John entered into a new business venture with his father and managed to grow and maintain that business through high school, college and law school.John is currently a co founder in over five different businesses. After law school, John decided that he wanted to help people like himself. He opened his own law practice and began working primarily with small business owners until he was introduced into the startup world. Ever since that time, John has worked with hundreds of startups and thousands of entrepreneurs from all different backgrounds in helping them achieve their goals. Having been an entrepreneur his entire life, John understands what it takes to create and maintain a successful business. He enjoys sitting down and working with his clients in figuring out each of their unique challenges.

ContractsCounsel verified
11 years practicing
Free Consultation

California-based small business attorney handling matters related to securities, mergers & acquisitions, corporate governance, and other business transactions.

ContractsCounsel verified
Associate Attorney
6 years practicing
Free Consultation

I joined Enterprise Law Group, LLP as an Associate in March 2020. My practice has involved a wide range of legal matters from commercial real estate, finance and international business transactions to litigation matters including commercial disputes, personal injury and medical malpractice. Proficient in Spanish, I graduated from the University of Kentucky College of Law, the Patterson School of Diplomacy and International Commerce, and the University of Southern California. Prior to my legal career, I sought diverse professional experiences. After graduating from college, I orchestrated my own volunteering experience in southern Peru with a small non-profit organization. Later I gained valuable professional experience as part of a U.S. Senate campaign, and after that I joined the public policy team at Greater Louisville, Inc., Louisville's Chamber of Commerce affiliate. Prior to law school, I embarked on a month long excursion with the Northern Outdoor Leadership School in Alaska, which gave me a new found appreciation for sustainability.

ContractsCounsel verified
Managing Attorney
11 years practicing
Free Consultation

Agnes Mombrun Geter is the Founder and Managing Attorney of Mombrun Law, PLLC. She is an experienced attorney and is a member of the Florida Bar, New Jersey Bar, and the Pennsylvania Bar. The firm's practice focuses on Estate Planning, Business Law, and Debt Settlement including IRS Debt Relief. The firm's goal is to simplify the law and provide clients with the confidence and information necessary to make their decisions. The firm also provides project-based legal services to other attorneys and law firms, along with assisting as personal counsel and local counsel on legal matters.

ContractsCounsel verified
Solo Practioner
40 years practicing
Free Consultation

Have over 40+ years of corporate and commercial law experience.

ContractsCounsel verified
Business Attorney
19 years practicing
Free Consultation

I am a business attorney with years of experience advising individual entrepreneurs and small businesses on issues ranging from entity selection/formation to employment law compliance, to intellectual property protection and exploitation. I often act as General Counsel for my clients fulfilling the legal function as part of a team of managers. I look forward to learning more about your business and how I may be of assistance.

Find the best lawyer for your project

Browse Lawyers Now

Want to speak to someone?

Get in touch below and we will schedule a time to connect!

Request a call