What is a convertible note?
A convertible note is a type of hybrid security that the holder can convert from debt into discounted shares of your startup at a future date. Typically, the conversion triggers upon your next round of equity funding.
In the meantime, convertible notes accrue interest at a fixed interest rate, but you typically don't have to make monthly payments like you would with a traditional business loan.
For context, the average length of a convertible note agreement is around 18 to 24 months.
If you reach a convertible note’s maturity date without the occurrence of a triggering event, your contract requires you to pay back the principal amount of the loan plus whatever interest has accrued.
However, many convertible noteholders are willing to extend the maturity date for you, as they’re more interested in holding equity than trying to collect on your debt. Less commonly, some notes automatically convert to shares.
Convertible note financing is popular among early-stage startups for being cheaper and easier to execute than traditional equity financing. In addition, it doesn't require you to have a startup valuation, which can be tough to get for new founders.
Like venture debt, convertible notes often function as a form of bridge financing designed to give you enough runway to reach your next priced round.
How do you structure a convertible note?
Convertible notes are structured around a discount rate, valuation cap, or both. When the triggering event occurs, one of these two factors will dictate how much equity the noteholder receives.
If your note uses a discount rate to calculate the conversion price, it works as if the noteholder spent cash equal to the value of the note on discounted shares of your startup. Typically, the discount ranges from 5% to 30%.
If your note uses a valuation cap, it sets an artificial limit on your company’s valuation for the calculation of the noteholder’s share price at the time of conversion.
The bigger the difference between the cap and the actual valuation, the more the noteholder benefits.
If your note includes a discount rate and a valuation cap, the convertible noteholder typically gets to use the option that grants them the most favorable outcome. That’s pretty common, with the valuation cap usually providing a lower price per share.
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Convertible note example
Say you’re the founder of an early-stage startup and could use some financing. You need about a year before you’re ready for an equity round, so in the meantime, you sign a convertible note term sheet that outlines the following:
- $200K principal balance
- 8% annual interest rate
- 24-month maturity period
- 20% discount rate
- $5M valuation cap
The conversion terms also stipulate that the next financing round that puts your startup valuation above $8M will be a triggering event. At that time, the noteholder can choose between exercising the valuation cap and the discount rate when acquiring their shares.
Twelve months later, you and your Series A investor agree to a $10M pre-money valuation, resulting in a price per share of $10. By that date, the note has accrued $16K in interest, making it worth $216K.
If your noteholder were to convert the note into shares using the 20% discount rate, the purchase price per share would be:
$10 – ($10 × 20%) = $8 per share
At $8 per share, your noteholder could purchase 27,000 shares.
If the noteholder were to convert the note into shares using the $5M valuation cap, they would receive a share purchase price of:
$10M valuation ÷ $10 per share = 1 million shares outstanding
$5M valuation cap ÷ 1 million shares = $5 per share
At $5 per share, your noteholder could purchase 43,200 shares. Since that’s the more favorable outcome for them, that’s the option they choose.
Convertible note structuring tips
A convertible loan note can be a powerful financing tool for early-stage startups, allowing you to raise capital efficiently without giving up equity or deciding on a valuation.
That said, there are some things you should consider before rushing to use them:
- Timing and maturity date: Timing is crucial when raising funds with convertible notes. Issuing them too far out from your next funding round can put pressure on you to repay the debt or convert before you’re ready. While you can often push back the maturity date, doing so causes additional interest to accrue.
- Preferred or common stock: Consider carefully whether you want your noteholders to receive preferred or common shares of stock upon conversion. Offering preferred stock can help you secure the funds but can also significantly complicate your capitalization table.
- Pre-money vs. post-money: Pay close attention to the difference between pre-money and post-money when structuring various aspects of your note, including the valuation cap and conversion timing. It has a significant impact on your eventual equity dilution.
In addition, make sure you understand the dilution risks when using convertible notes. If you issue too many of them, or if your valuation ends up too much higher than your valuation cap, it can dilute your ownership much more than you intended.
Circumstances when you'd want to avoid using a convertible note
Here are some circumstances in which you might want to stay away from convertible debt financing:
- Unclear timeline to funding round: Without a reasonable timeline for your next priced round, it’ll be tough to set an appropriate maturity date for a convertible promissory note. You’re at risk of having to repay the debt with cash or repeatedly extend the deadline, accruing significant interest.
- Worried about debt repayment: One of the downsides to convertible notes is that the noteholder may refuse to give you an extension and demand you repay your principal plus interest at the maturity date. If you can’t afford that risk, consider using a SAFE, which we’ll explain in the next section.
- Too many existing convertibles: Relying too much on convertibles to finance your startup can significantly dilute your ownership. In addition, it can complicate your cap table and potentially deter investors, making it more difficult to secure your next funding round.
Convertible notes have long been a popular funding tool for startups, but they’re not right for everyone. They have long-term implications for your ownership, so consider all your options before issuing one.
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Convertible notes vs. SAFE agreements
A SAFE agreement is another convertible instrument that the holder can eventually turn into equity shares of your company. They were designed to provide many of the same benefits of convertible notes without the drawbacks of a debt instrument.
SAFE is short for Simple Agreement for Future Equity. Introduced by the Y Combinator in 2013, they work a lot like convertible notes, but they don’t function as a loan in the period before they convert.
In other words, SAFEs don’t accrue interest, mature, or require you to comply with potentially burdensome debt regulations. As a result, they have fewer moving parts, which usually makes them easier to draft and negotiate.
For all those reasons, many startup founders prefer SAFEs to convertible notes, but not all investors are as keen on them. The lack of interest and repayment requirements increases their risk.
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