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What Is a Convertible Note?
A convertible note is a type of short-term debt that the holder can convert into equity in the issuing company. Convertible notes are usually used by seed investors who are investing in startups because they delay the task of deciding who much a company is worth until a later date when it's easier to perform a valuation. With the convertible note, the investor loans money to the startup in exchange for shares in the company as opposed to a future payout of the principal in addition to interest.
What Is a Senior Convertible Note?
A senior convertible note is a debt security that contains an option where the note will convert into a predefined number of shares. A senior convertible note takes priority over all other debt securities that the company may have issued. Like other types of debt investments, the senior convertible notes offer investors the ability to accumulate interest on their investments, but rather than a cash repayment, they are repaid in equity.
Why Should You Use a Convertible Note?
Startup companies and seed investors often choose to use convertible notes because they're fast and simple. Since convertible notes are a type of debt, companies can avoid the complication of actually issuing shares of stock. Additionally, if you're performing a typical round of funding for a startup, you need to have a valuation performed for the company, which can be difficult in the early stages of a business, such as pre-revenue or looking for funding to develop the technology you plan to sell.
In these situations, convertible notes can be advantageous, since they give startups the funding they need while enabling the business to go through the valuation process at a later date.
How Do Convertible Notes Work?
An investor will provide a startup company with a loan and repayment terms, i.e., the "note." The convertible note will include a due date when the note matures and the balance is due, along with any interest that the loan accrued during that time. Rather than repaying the note like a normal loan, the investor is paid with equity in the business. If the startup hasn't converted the note into equity by the maturity date, the investor can extend the date that the note will mature or call for an actual repayment.
However, the reason that investors typically want a convertible note is because a company has a strong growth trajectory. The investor is more interested in getting access to the equity at a heavily discounted rate than getting the loan repaid.
Pros and Cons of Convertible Notes
There are some advantages and disadvantages you should consider before moving forward with this type of funding:
- Fast and simple: The main advantage of financing your business through this type of funding is that it is fast and simple. Startups can often get the funding they need with only a simple promissory note.
- Delays valuation: Raising a convertible note rather than equity allows the company to delay a valuation. This is attractive to companies that haven't yet had traction in terms of revenue or a product. The company is able to push back the valuation in exchange for giving early investors a discount on the securities.
- Delays payments: Startups also don't need to worry about making payments to investors as they grow, which can support stronger daily cash flow.
- Giving away equity: The greatest downside for obtaining funding this way is that you'll eventually be giving away equity in your business. If you're unsure about whether you would want to give away ownership in your business in the startup phase, this type of financing may not be right for you.
- Risk of startup not raising subsequent equity financing: The other major drawback is the possibility that the company might not be able to raise subsequent equity financing. If the note matures but doesn't convert, then the company will likely not have the income available to repay the loan. Naturally, the best way for a company and its investors to avoid this scenario is to have a clear plan for success and failure both.
Image via Unsplash by Annie Spratt
Convertible Note Terms
Because a convertible note is still a type of loan, you'll need to have terms, as you would with a traditional business loan. Here are the four terms that are important for everyone to understand:
The valuation cap, also known as the conversation cap, caps the price where your notes will convert into equity. The lower the valuation cap, the better the terms are for the investor. For example, if the investor made a million-dollar investment in the startup and the company is later valued at $100 million, their equity would only be approximately 1%. However, if the valuation cap for the company is $10 million and they have made a million-dollar investment, then they have 10% equity in the company, a much higher stake.
Investors are generally given an additional discount on the price of the shares, compensating them for the risk they took by investing during the startup phase of the company. The conversion discount essentially allows the investor to buy more shares with their investment than later investors.
For example, if an investor invested $100,000 with a 20% discount rate, if the company does another round of fundraising and raises money at $1 per share, the investor receives stock at $0.80 per share. That means the investor gets 125,000 shares of the company stock rather than the 100,000 they would have gotten if they had waited and participated in later rounds of investing.
Because an investor is lending money, that loan will accrue interest in the same way that any loan would. However, rather than compensating the investor in cash for the additional interest, the interest would increase the number of shares that are issued when the note converts into equity. Interest rates for convertible notes are usually low.
The maturity date is the date where the note is due and the investor must be repaid.
Who Should Use Convertible Notes?
Convertible notes are ideal for early-stage startups that are in high-growth phases. The company should be talking to potential angel investors for seed funding so that when it is ready for a round of funding, the company will have a valuation and convertibles won't be of concern.
Because convertible notes are debt before converting into equity, the company needs to be growing rapidly and on the path towards a priced round for the notes to create value for investors. If this doesn't happen quickly enough and the note matures, the company may have to pay back the debt with interest if the investor doesn't extend the maturity date.
Convertible notes are also ideal for startup companies that want to secure funding quickly. Because the convertible note is just a loan, all you need is a promissory note to move forward with the deal, unlike a standard equity agreement that involves a detailed term sheet.
Finding the right funding is one of the most important steps for any startup business. However, it's important to carefully think through the pros and cons and for the startup to make smart decisions with its equity. Convertible notes are beneficial for early-stage companies, but they must know the terms. A contract lawyer can help you prepare a convertible note and feel confident in your decision. Contracts Counsel can provide you with easy access to vetted lawyers that cover over 30 industries. Contact us today to get started.
Meet some of our Convertible Note Lawyers
Pura Rodriguez, JD, MBA is the President and Managing Partner of A Physician’s Firm, based in Miami. She represents healthcare providers from different specialties in a broad range of issues, including contract review, business planning and transactions, mergers and acquisitions, vendor and contract disputes, risk management, fraud and abuse compliance (Anti-Kickback Statute and Stark), HIPAA compliance, medical staff credentialing, employment law, and federal and state regulations. She also assists providers in planning their estates, protecting their assets, and work visa requirements.
Jaclyn is an experienced intellectual property and transactional attorney residing and working in NYC, and serving clients throughout the United States and internationally. She brings a targeted breadth of knowledge in intellectual property law, having years of experience working within the media, theater, PR and communications industries, and having represented clients in the music, entertainment, fashion, event production, digital media, tech, food/beverage, consumer goods, and beauty industries. She is an expert in trademark, copyright, and complex media and entertainment law matters. Jaclyn also taught as an Adjunct Professor at Cardozo School of Law, having developed and instructed the school’s first Trademark Practicum course for international students. In her spare time, Jaclyn’s passion for theater and love for NYC keeps her exploring the boundless creativity in the world’s greatest city!
A bilingual attorney graduated from J.D. with a C.P.A. license, an M.B.A. degree, and nearly ten years of experience in the cross-border tax field.
Experienced and business-oriented attorney with a great depth of contract experience including vendor contracts, service contracts, employment, licenses, operating agreements and other corporate compliance documents.
With over 21 years of practice, Chet uses his vast experiences to assist his clients in the most efficient manner possible. Chet is a magna cum laude graduate of University of Miami School of Law with an extensive background in Business Law, Commercial Real Estate, Corporate Law, Leasing Law and Telecommunications Law. Chet's prior experience includes 5 years at two of the top law firms in Georgia and 16 years of operating his own private practice.
Steve Clark has been practicing law in DFW since 1980. He is licensed in both Texas and Louisiana state and federal courts. He concentrates his practice on business clients and their needs. He has been a SuperLawyer in Texas since 2011, and is Lead Counsel rated in Business Law. He is also a Bet the Company litigator in Texas.
I am a top-performing bi-lingual legal services professional with a proven record of success. Reputation of assessing and evaluating client’s needs and providing individualized solutions in line with those needs while efficiently handling multiple tasks simultaneously. Able to create a collaborative work environment ensuring business objectives are consistently met. Seeking an attorney role within a legal setting to apply skills in critical thinking, executive communications, and client advocacy.