Jump to Section
Need help with a Convertible Note?
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
Terry Brennan is an experienced corporate, intellectual property and emerging company transactions attorney who has been a partner at two national Wall Street law firms and a trusted corporate counsel. He focuses on providing practical, cost-efficient and creative legal advice to entrepreneurs, established enterprises and investors for business, corporate finance, intellectual property and technology transactions. As a partner at prominent law firms, Terry's work centered around financing, mergers and acquisitions, joint ventures, securities transactions, outsourcing and structuring of business entities to protect, license, finance and commercialize technology, manufacturing, digital media, intellectual property, entertainment and financial assets. As the General Counsel of IBAX Healthcare Systems, Terry was responsible for all legal and related business matters including health information systems licensing agreements, merger and acquisitions, product development and regulatory issues, contract administration, and litigation. Terry is a graduate of the Georgetown University Law Center, where he was an Editor of the law review. He is active in a number of economic development, entrepreneurial accelerators, veterans and civic organizations in Florida and New York.
I'm a Washington-licensed lawyer specializing in trademark practice and with an extensive trademark education and academic background. I currently work with domestic and international businesses seeking trademark protection in the U.S. by conducting trademark searches, providing legal advice, submitting USPTO applications, and preparing responses to office actions. I'm passionate about trademark law and always looking forward to helping small and medium businesses promote their value by having a registered federal trademark. If you have questions or concerns about trademark/copyright/IP licensing and require legal advice, feel free to contact me so we can have a first chat.
Mr. Pomeranz serves as the principal of Pomeranz Law PLLC, a boutique law firm representing clients across myriad industries and verticals. Before founding the firm, Mr. Pomeranz served as Senior Vice President, Legal & Compliance and General Counsel of Mortgage Connect, LP in 2017. Mr. Pomeranz also served as Counsel, Transactions for Altisource Portfolio Solutions S.A. (NASDAQ: ASPS) beginning in 2013, and was based in the company’s C-Suite in Luxembourg City, Luxembourg. Mr. Pomeranz began his career with Mainline Information Systems, Inc. as an in-house attorney.
I have 10 years experience providing general counsel, in the form practical and timely legal advice, under strict deadlines to individuals and various business unit stakeholders, balancing commercial needs with legal concerns at large corporations and start-ups. I am skilled at reviewing, analyzing, drafting and negotiating commercial and government contracts globally for the procurement and sale of services and goods. I also help clients ensure compliance with regulations (including data privacy), laws and contractual obligations and protect, enforce and exploit intellectual property rights and support in the development of IP strategy. I am a Certified Information Privacy Professional/United States (CIPP/US) licensed by the IAPP - International Association of Privacy Professionals.
Over 15 year experience drafting, reviewing and negotiating contracts both as in-house counsel and in law firms, including my own law firm.
Rinky S. Parwani began her career practicing law in Beverly Hills, California handling high profile complex litigation and entertainment law matters. Later, her practice turned transactional to Lake Tahoe, California with a focus on business startups, trademarks, real estate resort development and government law. After leaving California, she also served as in-house counsel for a major lending corporation headquartered in Des Moines, Iowa as well as a Senior Vice President of Compliance for a fortune 500 mortgage operation in Dallas, Texas prior to opening Parwani Law, P.A. in Tampa, Florida. She has represented various sophisticated individual, government and corporate clients and counseled in a variety of litigation and corporate matters throughout her career. Ms. Parwani also has prior experience with state and federal consumer lending laws for unsecured credit cards, revolving credit, secured loans, retail credit, sales finance and mortgage loans. She also has served as a special magistrate and legal counsel for numerous Florida County Value Adjustment Boards. Her practice varies significantly from unique federal and state litigation cases to transactional matters. Born and raised in Des Moines, Iowa, Ms. Parwani worked in private accounting for several years prior to law school. Her background includes a Certified Public Accountant (CPA) certificate from Iowa (currently the license is inactive) and a Certified Management Accountant (CMA) designation (currently the designation is inactive). Ms. Parwani or the firm is currently a member of the following organizations: Hillsborough County Bar Association, American Bar Association, Tampa Bay Bankruptcy Bar Association, National Association of Consumer Bankruptcy Attorneys, and the American Immigration Lawyers Association. She is a Fellow of the American Bar Association. Ms. Parwani is a frequent volunteer for Fox Channel 13 Tampa Bay Ask-A-Lawyer. She has published an article entitled "Advising Your Client in Foreclosure" in the Stetson Law Review, Volume 41, No. 3, Spring 2012 Foreclosure Symposium Edition. She is a frequent continuing legal education speaker and has also taught bankruptcy seminars for the American Bar Association and Amstar Litigation. She was commissioned by the Governor of Kentucky as a Kentucky Colonel. In addition, she teaches Immigration Law, Bankruptcy Law and Legal Research and Writing as an adjunct faculty instructor at the Hillsborough Community College Ybor campus in the paralegal studies program.
Possesses extensive experience in the areas of civil and transactional law, as well as commercial litigation and have been in practice since 1998. I addition I have done numerous blue sky and SEC exempt stock sales, mergers, conversions from corporations to limited liability company, and asset purchases. I have worked in commercial litigation, corporate and transactional law, intellectual property and bankruptcy. In recent years I have expanded my practice to include family law, personal injury, medical malpractice, and wrongful death.