The Convertible Note Guide: Key Components and More

A convertible note is a type of financing instrument that's gaining popularity among startups and investors alike.

It's essentially a loan that converts into equity at a later date, allowing investors to take a chance on a company without having to decide on a valuation.

The key components of a convertible note include the principal amount, interest rate, and conversion terms.

The principal amount is the initial amount borrowed by the company from the investor.

The interest rate determines how much the company has to pay back to the investor over time.

The conversion terms specify when and how the note can be converted into equity.

There are different types of conversion terms, including fixed conversion, discount conversion, and cap conversion.

A convertible note is essentially a loan that converts into equity when a startup raises a new round of funding.

It's a popular financing option for early-stage companies.

Convertible notes are typically used in seed funding rounds.

They can be issued by the company itself or by investors.

A convertible note is essentially a loan, but it's often used in place of equity.

The interest rate on a convertible note is usually higher than a traditional loan.

The note typically has a maturity date, after which it converts into equity.

This date is usually tied to a future funding round.

The conversion price is the price at which the note converts into equity.

It's typically set at a premium to the current valuation of the company.

The premium is usually around 20-30%.

Convertible notes are relatively short and easy to interpret, making the financing process easier for early-stage startups.

The terms of a convertible note are outlined in a standardized version, such as a SAFE (Simple Agreement for Future Equity), which is a popular method of convertible financing in the US.

Important terms in a convertible note include interest rates, maturity dates, and conversion terms. Investors lend with the potential to convert debt into company shares.

Here are the key components and terms of a convertible note:

A discount on a convertible note applies to the rate at which the convertible note holder can buy shares at a subsequent equity financing.

A convertible note is a type of financing that's commonly used by startups to raise capital. It's structured as a loan, but with some key differences that make it unique.

Convertible notes have an interest rate, which determines the amount that must be paid back in addition to the principal amount. This interest rate is a key component of the note.

The maturity date of a convertible note is the date when the noteholder is entitled to repayment, or an extension of, the note. This date is usually specified in the agreement between the company and the noteholder.

A discount rate, also known as a conversion discount rate, is the rate at which the convertible note holder can buy shares at a subsequent equity financing. For example, a 20% discount rate means the note holder can buy shares at 80% of their value.

The discount rate can be based on the pre-money valuation or the post-money valuation of the company. The pre-money valuation is the company's value before the new investment, while the post-money valuation is the company's value after the new investment.

Here's a summary of the key components of a convertible note:

Interest is a key component of convertible notes, and it's essential to understand how it works. Convertible debt normally means interest payments when originally issued as loans.

The interest rate can range from very minimal interest up to north of 10%. For example, the UK government's Future Fund investment vehicle has standard terms of 8%.

As the convertible note accrues interest over time, the principal amount increases. This interest is generally paid out in shares when the convertible note matures or is converted to equity.

The interest rate is calculated as a percentage of the convertible note's principal. For instance, if the principal is $100,000 and the annual interest rate is 5%, the interest that accrues over one year will be $5,000.

To calculate the accrued interest, multiply the convertible note's interest rate by the number of years that have passed since the convertible note was issued. This means that the convertible note's principal has increased from $100,000 to $130,000.

Here's a simple example of how interest accrues over time:

As you can see, the principal amount increases over time, and the interest rate remains the same. This is an important consideration when evaluating the terms of a convertible note.

In a funding round, a convertible note can significantly affect the equity stakes of founders, employees, existing and new investors. The post-money valuation at the subsequent funding round determines how the stakes are affected.

There are two ways to calculate the post-money valuation, and the choice depends on the method used. This can lead to different outcomes for the stakeholders involved.

The cap table is where you keep track of all holders of equity, but convertible notes sit between debt and equity, making it sensible to register them in your equity software ready to be incorporated into the cap table.

This provides clarity for financial modeling and for convertible note holders, who know where they stand relative to your shareholders.

Here's a breakdown of the share ownership data after the investment takes place and the note is converted to equity:

The founders are diluted by a total of 20.32%, and the new investor receives 11.95% of the equity. The early investor that converted its note into shares owns 8.37% of the company’s equity.

A valuation cap on a convertible note protects investors if a startup’s value increases before conversion. If the valuation cap is lower than the actual startup value, investors get more shares.

The valuation cap sets the highest valuation for conversion, regardless of the actual startup value. For example, if a startup is given a post-money valuation of $20 million in its Series A round, an investor’s convertible note may convert at a lower valuation if the valuation cap is $10 million.

Here's an example of how the valuation cap works:

If another investor invests the same $1 million without a convertible note, they'd only get a 5% share of the company.

Convertible notes offer a range of benefits for startups and investors alike.

They provide a great way to get funding without setting a valuation, which can be a huge advantage for early-stage companies.

This is because convertible notes convert into equity at a later date, giving businesses more time to grow and generate revenue.

Convertible notes can help attract more investors, as they are often more attractive than equity financing.

One of the main benefits for businesses is that they remove the pressure of paying off debts immediately.

This allows businesses to focus on growth and development, rather than worrying about debt repayment.

For investors, convertible notes offer a higher potential return on investment (ROI) due to discount rates.

This means investors can get more equity for their investment than they would with equity financing.

Convertible notes also offer a higher level of liquidity than equity financing, making it easier for investors to cash out their investment if needed.

Here are some key benefits for both parties:

Overall, convertible notes can provide an easy way to finance a business without the complexity and time involved in many startup financing rounds.

A convertible note is a type of loan that can be converted into equity in a company. It's essentially a loan with a twist: instead of repaying the loan with interest, the investor gets shares in the company.

The conversion process typically occurs during a later funding round, known as a qualified financing round. The convertible note sets the minimum capital needed for conversion, and when triggered, the loan amount plus interest turns into equity at a predetermined rate.

Most convertible notes come with a valuation cap, which is used to determine the maximum share price a convertible noteholder will pay at the next conversion event. This cap protects investors if a startup's value increases before conversion. If the startup's value exceeds the cap during conversion, investors get more shares.

Here's a quick rundown of the key aspects of a convertible note:

A convertible note is essentially a loan that can be converted into equity. It's a flexible financing option for startups and small businesses.

Most convertible notes come with a maturity date, which is the date when the loan is due to be repaid.

A convertible note agreement is reached between the investor and the startup, outlining the terms of the loan. This agreement is crucial in determining how the loan will be converted into equity.

The conversion event is triggered when a fundraising round occurs, at which point the investor can convert their loan into equity. This is based on the valuation cap, which is the maximum share price the investor will pay at the next conversion event.

The valuation cap is used to determine the amount of equity owed to the investor, taking into account the principal amount and any interest accrued prior to the conversion event.

A convertible note is a loan to an early-stage company that can be converted into equity at a later date. It's designed to give the company flexibility in funding and protect investors from sudden valuation increases.

The note typically has a maturity date, which is the date by which the debt should be repaid, including interest. This date can range from 12 to 36 months in the future, but it's common for companies to aim to convert the debt into equity before the loan is repaid.

A convertible note usually includes provisions that determine how it will convert into equity and what happens if it never does. Most convertible notes come with a valuation cap, which sets the maximum share price a convertible noteholder will pay at the next conversion event.

Here's a breakdown of the key components of a convertible note:

The conversion process typically happens when a startup raises a certain amount of capital in a qualified financing event. The convertible note sets the minimum capital needed for conversion, and when triggered, the loan amount plus interest turns into equity at a predetermined rate, often at a discount compared to the investor's share price in the funding round.

For example, if an investor invests $100,000 in a convertible note with a valuation cap of $6 million, a discount rate of 20%, and a maturity date of 5 years, the conversion would go something like this:

In contrast, if the investor hadn't used a convertible note, that same $100,000 investment would only be worth 5,000 shares.

Calculating interest on a convertible note is a crucial step in understanding how they work. The interest rate can range from minimal to over 10%, with a helpful benchmark being the UK government's Future Fund investment vehicle, which has standard terms of 8%.

The interest rate is the percentage of the convertible note's principal that will accrue interest over time. For example, if the principal of the convertible note is $100,000 and the annual interest rate is 5%, the interest that accrues over one year will be $5,000.

To calculate interest, you simply multiply the convertible note's interest rate by the number of years that have passed since the convertible note was issued. This means that the convertible note's principal has increased from $100,000 to $130,000, as seen in the example of a 6% interest rate over 5 years.

The interest earned is then added to the principal when converting the debt to equity. For instance, if the interest rate is 5% and the principal is $500,000, the interest earned after 1 year would be $25,000.

Convertible notes are not without their risks and limitations. Investors face risks of equity dilution upon conversion and the possibility of repayment failure leading to bankruptcy. Conflicts may arise if conversion terms do not favor all parties.

One of the biggest risks for fundraisers is the potential for dilution of ownership when notes convert into equity. This can happen if subsequent rounds occur at lower valuations. Fundraisers may also have to deal with complex legal documentation and risk of investor dissatisfaction.

Uncertainty about the company's true valuation until conversion occurs can be a challenge for both investors and fundraisers. This lack of clarity can lead to strained relationships and make it harder to secure future funding.

Convertible notes can be a great way to get funding without setting a valuation, but they come with some significant limitations.

One of the main limitations is the lack of control for noteholders. They are not stakeholders of the company until their debt is converted to equity, which means they have limited rights.

Another limitation is the unpredictability and uncertainty of convertible debt. Noteholders don't know when the qualified financing round will happen, how much equity they'll own, or if all the key clauses are agreed on and specified in the contract.

This can lead to complex terms and potential dilution risks, which can be a challenge for both investors and fundraisers.

Here are some of the specific disadvantages of convertible notes:

These limitations can make convertible notes a less attractive option for some startups and investors, and it's essential to carefully consider the pros and cons before making a decision.

If the conversion event never occurs, the investor may not receive the expected return on investment.

In some cases, the startup's existing stockholders may vote to be acquired by a larger company, which can lead to a cash payout for the principal amount invested plus any accrued interest.

The investor may receive a cash payout, but this outcome is not ideal for them.

There's always the possibility of the company struggling to manage its cash flow, failing to attract new investors, and having to default on a convertible note.

In such cases, the seed investment can go up in smoke, and the investor may have limited recourse.