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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
Creative, results driven business & technology executive with 24 years of experience (13+ as a business/corporate lawyer). A problem solver with a passion for business, technology, and law. I bring a thorough understanding of the intersection of the law and business needs to any endeavor, having founded multiple startups myself with successful exits. I provide professional business and legal consulting. Throughout my career I've represented a number large corporations (including some of the top Fortune 500 companies) but the vast majority of my clients these days are startups and small businesses. Having represented hundreds of successful crowdfunded startups, I'm one of the most well known attorneys for startups seeking CF funds. My engagements often include legal consultation & advisory roles, drafting of NDAs, TOS & Privacy Policies, contracts and corporate law, business strategy advice & consulting, in-house counsel, Founder & entrepreneur guidance and other roles as needed by my clients. I hold a Juris Doctor degree with a focus on Business/Corporate Law, a Master of Business Administration degree in Entrepreneurship, A Master of Education degree and dual Bachelor of Science degrees. I look forward to working with any parties that have a need for my skill sets.
Seasoned technology lawyer with 22+ years of experience working with the hottest start-ups through IPO and Fortune 50. My focus is primarily technology transactions with an emphasis on SaaS and Privacy, but I also provide GC services for more active clients.
I am a California-barred attorney specializing in business contracting needs. My areas of expertise include contract law, corporate formation, employment law, including independent contractor compliance, regulatory compliance and licensing, and general corporate law. I truly enjoy getting to know my clients, whether they are big businesses, small start-ups looking to launch, or individuals needing legal guidance. Some of my recent projects include: -drafting business purchase and sale agreements -drafting independent contractor agreements -creating influencer agreements -creating compliance policies and procedures for businesses in highly regulated industries -drafting service contracts -advising on CA legality of hiring gig workers including effects of Prop 22 and AB5 -forming LLCs -drafting terms of service and privacy policies -reviewing employment contracts I received my JD from UCLA School of Law and have been practicing for over five years in this area. I’m an avid reader and writer and believe those skills have served me well in my practice. I also complete continuing education courses regularly to ensure I am up-to-date on best practices for my clients. I pride myself on providing useful and accurate legal advice without complex and confusing jargon. I look forward to learning about your specific needs and helping you to accomplish your goals. Please reach out to learn more about my process and see if we are a good fit!
I am a NY licensed attorney experienced in business contracts, agreements, waivers and more, corporate law, and trademark registration. My office is a sole member Law firm therefore, I Take pride in giving every client my direct attention and focus. I focus on getting the job done fast while maintaining high standards.
A twenty-five year attorney and certified mediator native to the Birmingham, Alabama area.
Longtime corporate real estate counsel with specialities in commercial leasing, contracts, corporate governance, and general small business/startup/entrepreneurship legal issues.
I absolutely love helping my clients buy their first home, sell their starters, upgrade to their next big adventure, or transition to their next phase of life. The confidence my clients have going into a transaction and through the whole process is one of the most rewarding aspects of practicing this type of law. My very first class in law school was property law, and let me tell you, this was like nothing I’d ever experienced. I remember vividly cracking open that big red book and staring at the pages not having the faintest idea what I was actually reading. Despite those initial scary moments, I grew to love property law. My obsession with real estate law was solidified when I was working in Virginia at a law firm outside DC. I ran the settlement (escrow) department and learned the ins and outs of transactions and the unique needs of the parties. My husband and I bought our first home in Virginia in 2012 and despite being an attorney, there was so much we didn’t know, especially when it came to our HOA and our mortgage. Our real estate agent was a wonderful resource for finding our home and negotiating some of the key terms, but there was something missing in the process. I’ve spent the last 10 years helping those who were in the same situation we were in better understand the process.