What Is A Convertible Note and How Does It Work?

What Is a Convertible Note?

A convertible note, also called convertible debt, is a loan (debt) from an investor which, under certain circumstances, may be converted into stock in the company (equity). Convertible notes are a popular instrument for several reasons.

Advantages

  • Well-established.Convertible notes have been widely used for the last decade. Therefore, they are familiar and fast, which equates to less costs.
  • Quick and easy.Convertible note financing has simpler terms, thus, it takes less time to negotiate and complete due diligence than a priced equity round.
  • Flexible.Unlike equity financing, founders retain operational freedom, which can be crucial to a seed stage company.
  • Delay valuation.Using convertible notes allows the company to delay a formal valuation
    of the company until the next financing round.

Disadvantages

  • Repayment.Convertible notes usually come with a maturity date of 18 to 24 months, at which time the loan either needs to be repaid or converted into equity. There is a low valuation cap. A valuation cap is the highest valuation at which the convertible note would be converted into equity (regardless of discount).
  • Not as Simple as a SAFE.Though the convertible note is much simpler than raising a priced equity round, it’s still not as simple as the Simple Agreement for Future Equity.

How Does It Work?

Depending on the document set you use, there are either two or three documents required to close the investment: term sheet, promissory note and purchase agreement.

  • Term sheet.The term sheet is a high-level summary of the deal terms. In a pre-seed round company, counsel will often draft their own term sheet. However, if the investor is a venture capital firm, they may draft the term sheet.
  • Convertible promissory note.The convertible promissory note articulates the terms of
    the investment in detail.
  • Note purchase agreement.If the note purchase agreement is included, it sets forth additional representations and warranties, as well as administrative provisions.

What Are the Most Crucial Provisions of a Convertible Note?

Principle and Interest

As with any loan, the investor is lending the company a certain amount of capital—the principal—and expects that to be paid back plus accrued interest. Generally, the interest rate is a simple (not compounding) interest rate of between 4-6% per year. Seed investors are not really looking to profit from interest payments. Thus, it is unusual for experienced seed investors to demand higher interest rates. If a convertible note investor is asking for a high interest rate, you should be alarmed and consider not working with them. This is a sign of an inexperienced startup investor.

Maturity

A convertible note is a loan from the investor to the company. Just like any loan, there is a date when the amount lent (the principal) plus any accrued interest must be repaid. This is known as the maturity date. Convertible notes usually come with a maturity date of 18 to 36 months. Ideally, the maturity date is after the date the founder intends to raise their next round of funding. When setting a maturity date, founders should carefully consider how long it would take for the company to make enough progress to raise the next round of financing. So, if the company intends to raise their next round in 18 months, you may want to set the maturity date at 24 months to give a little buffer.

Conversion

Conversion terms will likely be where the parties spend the bulk of negotiation time. The primary function of a convertible note is for the principal amount of the note to convert automatically into shares of the issuer’s capital stock in connection with the issuer’s next financing.

  • Qualified financing.Financing will not trigger an automatic conversion unless a minimum amount of new capital is raised in the financing. Typically, this threshold is $1 million. The goal of setting this threshold is to protect the noteholders from situations where notes convert to equity in a financing that leaves the issuer inadequately capitalized.

    Upon conversion, the noteholder’s shares will have the exact same preferences, rights and restrictions as the preferred shares of the new investors in that round of funding (new investors). So, founders should keep in mind that when they are negotiating the terms with the new investors, they are negotiating the terms for the new investors but also for the previous convertible noteholders.

    The number of preferred shares that convertible note investors will receive depends on whether there is a discount and/or a cap.

  • Discount.Convertible notes will likely provide for a discounted conversion into the issuer’s equity. This provision is included to recognize the holder for the added risk taken by investing earlier in the startup. A typical discount off of the price paid by the subsequent equity holders would be 15-25% with 20% being by far the norm. Conversion discounts may be higher in investments with more perceived risk, either because the note may have a longer maturity or because of the specific circumstances of the issuer.

    However, a discount alone may not be sufficient in protecting an early investor’s interest. In a scenario where the amount raised in a subsequent round of financing is significantly higher than the seed round financing, the early investor might be left with a smaller percentage of the company than expected. Accordingly, some investors will use a valuation cap in their convertible notes to account for such circumstances.

  • Valuation Cap.One of the most heavily negotiated terms in convertible notes is the valuation cap. This may also be referred to as a price cap, or simply“the cap.

    What is a valuation cap, and why does it receive so much attention? A valuation cap is a projection of the maximum price (ceiling) at the subsequent round of equity financing rather than an actual pre-money valuation. Founders should always keep future rounds in mind when they set a cap on their convertible note. If the cap is too low, founders risk giving up too much equity to the convertible note investors and diluting them selves in the process. Setting a valuation cap at an appropriate level requires understanding your company thoroughly and knowing the commercial value your business can bring.

    The best-case scenario for founders is for the convertible note to be uncapped but discounted. The discount allows the convertible note investor to be rewarded for their early risk. But it avoids the problem of trying to set some random value on the company, which could turn out to be incredibly high or low.

What Happens At the Maturity Date?

Unlike other loans you may be familiar with, such as student loans or auto loans, most convertible notes don’t have monthly payments. Instead the entire principal plus interest comes due at the maturity date.

Some convertible notes allow the total amount to be converted into equity at the maturity date at a prescribed valuation cap. Depending on the negotiations, the company or the noteholder may have the right to elect conversion at maturity.

However, if that clause is not in the convertible note, then the reality is that the company likely does not have the funds to cover the repayment obligation and certainly not with interest added. Whereas the noteholder could call the note and force the liquidation of the company, in practice, this rarely happens. Generally, the company and the noteholder mutually agree to extend maturity of the convertible note.

What Happens if the Company Is Acquired Before the Note Converts?

From time to time, a company will be acquired after it has issued convertible notes but prior to a qualified financing. As with everything on the term sheet, this is a point of negotiation. The options are cash payout or conversion of debt to equity.

With a cash payout, the company will pay the investor a certain amount of money. Investors will look to negotiate a two-time or three-time multiple of the total amount. In a conversion scenario, the investor converts the debt to equity based on either the cap or an alternative valuation mechanism negotiated between the founder and investor.

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