What is a convertible note? (explanation, benefits, example)

What is a convertible note?

A convertible note is a commercial bond that can be converted to stock once a predetermined milestone has been reached. Early-stage companies often use convertible notes to attract new investors and raise money for startups. The company predetermines the number of shares awarded when the convertible note converts.

Convertible note financing typically precedes a series A round. Depending on the business's financial needs, it can be used in place of or in conjunction with venture funding. Protections trigger the conversion when share prices hit a certain level, so the upside for investors is limited. Most do it to secure future equity in the company. 

The convertible note terms are expressed in a ratio, e.g., 1:40 means one note for forty shares. Another clause may also cover liquidation rights if the business fails. The complexity of the term sheets makes this type of bond less popular than a traditional commercial bond. Most of the risk is taken by the investor.

Convertible notes are a hybrid of debt and equity

Startups use convertible notes to take on debt, which they can repay with equity when the company matures. While still in debt form, convertible notes don’t come with voting rights, but depending on how the agreement is structured and whether the company issues common stock or preferred stock, rights may be awarded upon conversion.

Convertible debt generally looks better on the balance sheet than bank debt financing because it’s an obligation that can be met with equity. Convertible noteholders typically show up as long-term liabilities, whereas loan payments are monthly short-term debt. That makes a difference when calculating cash flow and managing expenses.

Convertible note vs. SAFE note vs. KISS note

A convertible note is a debt instrument with a maturity date of usually eighteen to twenty-four months. A Simple Agreement for Future Equity (SAFE) note is an equity agreement with no maturity date that does not involve debt. Convertible notes pay interest, providing short-term income for the investor. SAFE notes do not pay interest.

The conversion rules for convertible notes and SAFE notes are different. To convert a convertible note, the company must raise a certain amount of capital. SAFE notes can convert at any amount raised during the next preferred stock round. They’re also more straightforward and have a valuation cap, making them popular for fundraising.

A KISS note has a stated interest rate and a maturity date of eighteen months. After the maturity date, the investor can convert the investment amount into preferred stock. That won’t give them voting rights, but it does guarantee they’ll get paid first in the event of an acquisition or liquidation. Some preferred stock also pays dividends.

When does a convertible note mature?

A convertible note typically matures in eighteen to twenty-four months. It can convert automatically or be triggered by the lender. If the note doesn’t convert by maturity, the company and investor can extend the term another year. Timing is critical for both parties. One strategy is to convert the note during an acquisition or equity round of funding.

Investors may be able to convert their note before maturity and get a conversion discount on the stock price. The discount rate is preset in the original agreement, and a limit is placed on the valuation to determine that conversion price. If the investor doesn’t convert the note before maturity, the company must repay the principal and interest in cash.

Why use convertible notes?

Raising capital is hard for early-stage startups. Seed investors are typically close associates, friends, or family. You can offer them promissory notes. Venture capital is hard to get with a pre-money valuation. Venture funds are looking for equity funding deals you can’t offer. That leaves convertible notes you can repay with equity at a later date.

Noteholders are future shareholders because they’ll have voting rights after your next round of funding. Use that as part of the pitch when you’re raising capital.

Debt financing

Acquiring debt financing through traditional business banks is another challenge for startups. Loan approvals typically require several years of financial records, something you won’t have in the early stages. Convertible notes are a form of debt financing that doesn’t require wading through all that red tape. You also won’t need to deal with monthly loan payments.

Convertible notes are categorized as debt securities. They are included on your cap table with stocks, warrants, and equity ownership grants. Loans appear on the balance sheet as short-term liabilities because they require repayment in monthly installments. The accrued interest is deductible, but the monthly expense affects your liquidity ratios.

What companies are good fits for convertible notes?

Convertible notes are a good source of financing for companies that have already acquired seed funding but have not yet reached the next financing round, typically an equity financing round. The principal amount raised can cover operating expenses and growth initiatives as you prepare for a potential initial public offering (IPO) or acquisition.

Managing dilution when your company needs financing can be tricky. Everyone wants a piece of the pie. Banks don’t want equity, but the cost of debt financing could lower your company’s valuation in your next equity round. Convertible notes don’t come with monthly payments, and the equity award can be controlled.

Terms

Convertible note agreements have several provisions that must be negotiated before a deal is made. The language can be fairly complex, so it’s important to understand the terminology we have listed below. Here are some of the key points of a convertible note agreement:  

Interest rate

The interest rate on a convertible note is typically 5-8%. It accrues simply over the agreement's term, typically eighteen to twenty-four months. Longer-term deals can range as long as thirty-six months. These details are negotiated before the agreement is signed. Once that happens, they cannot be changed, so be careful about what you agree to.

Conversion provisions

A convertible note is a debt instrument that converts to equity. The agreement documents this process. The first element is the conversion ratio, which states how many shares will be received when the single note is converted. For instance, a 1:25 ratio means the noteholder received twenty-five shares in exchange for the note upon conversion.

Conversion discount rate

The discount rate is a percentage of the stock value the noteholder pays when they convert their note to equity. For instance, if the stock price is $10 per share and the discount rate is 20%, the noteholder pays $8 per share to convert. That amount then becomes their cost basis for tax reporting purposes. Speak with your accountant to learn more about that.

Maturity date

The maturity date is the day the convertible note expires. If it hasn’t been converted, the company must pay the note's value and any accumulated interest. If the note is converted before maturity, the noteholder receives equity at the discounted rate stipulated in the convertible note agreement. The maturity date can be extended if both parties agree.

Valuation cap

A convertible note is a debt instrument that doesn’t appear as a short-term liability on your balance sheet. It shows up on your cap table because it represents equity promised to an investor. Future investors and venture funds will want to see that before you can execute your next fundraising round. Notes will also dilute ownership shares when they convert.

Benefits of using convertible notes

Convertible notes give startups a simple and convenient way to raise funds before they get an official valuation. They are a debt instrument that doesn’t require a monthly debt payment, so they don’t affect liquidity ratios or cash flow. Here are some of the benefits of using them:

Simple (as legal documents)

The legal documentation for convertible notes has several parts, but the language is fairly straightforward. Investors will find it easy to understand because it's a simple debt-to-equity conversion. The investor is lending money to the company and getting paid back in stock instead of cash. Maturity dates and discount rates are simple concepts to explain. 

Allows a company to delay placing a value on itself

A convertible note is classified as a debt until it converts. That means it doesn’t factor into the company’s valuation. It also means you can issue a convertible note before the company's valuation is set. That’s why this form of funding is so popular with startups. The company can raise funds with notes and delay placing a value on itself.

Can be a straightforward way to raise some cash

Banks can take weeks to approve business loans or lines of credit, and venture funding could take months. Convertible notes can be negotiated and signed the same day they’re issued, generally making them a fast and straightforward way to raise cash.

The large benefit to investors…if things go well

Buying stock at a discount can produce a lucrative capital gain for investors, given the share price increases. Convertible notes also come with a guarantee of repayment if the note doesn’t convert before maturity. Companies can convert at will if they want to do another fundraising round. Few investments come with that kind of two-party protection.

Drawbacks of convertible notes

Investing and risk go hand in hand. The company takes a risk when it issues a convertible note because it needs to award equity at some point. The investor risks getting nothing if the company doesn’t do another fundraising round. Here’s a list of those and other drawbacks:

Worthless if the company fails to secure future funding

A convertible note converts when the company secures future funding. If that doesn’t happen, the company will typically pay the note back in cash, including the principal and accrued interest. That makes it worthless for investors looking for a stake in the company. It also affects the company because the cash layout is reported as an expense. 

Giving away potentially more equity than planned

The flip side of the scenario above is the stock overperforming and the company having to give up more value than anticipated. This issue gets compounded if the noteholder has a significant discount rate. Giving away high-priced stock at a discount prevents the company from selling it for full price to other investors or through a public offering.  

Time-consuming to prepare

The deal can be signed in a few minutes, but preparing the paperwork takes time. Negotiations for the term and discount rate could also go on for a while, particularly if you’re dealing with savvy investors with other options. Hope for the best, but plan for the worst. The terms of the agreement won’t be in your favor if you appear desperate. 

Poor planning can lead to complications in the future

Several parts of a convertible note agreement can hurt your company if you’re not careful. The first is the dilution of your ownership shares when the note converts. Another is the cash obligation if you allow the note to reach its maturity date. Poor planning can lead to complications in the future. Consider all the potential consequences carefully.

FAQs about convertible notes 

What is a convertible note, and how does it work?

A convertible note is a hybrid of debt and equity. When investors give the company money, it starts out as debt, but it converts to common stock.  

What is the main advantage of a convertible note?

The main advantage of a convertible note is that it is not debt that needs to be paid back in monthly installments. Repayment is made with equity.  

What happens if you don't convert a convertible note?

If a convertible note is not converted before the maturity date, the company is liable for repayment in cash, including the principal and accrued interest.

Why would a company issue convertible notes?

Startups often issue convertible notes when they can’t get bank financing or venture funds. This is an early-stage form of financing for companies that don’t yet have a valuation.  

What happens to a convertible note if startup fails?

The convertible noteholder becomes a creditor if a startup fails. That gives them the right to be repaid before common shareholders. 

What is the typical interest rate on a convertible note?

Convertible notes typically average a 5-8% interest rate.  

Wrap-up

Convertible notes are a good form of financing for startups in the pre-valuation stage. The note is recorded on the balance sheet as a long-term liability and shows up on the cap table, but it doesn’t show up as an expense that can affect liquidity. It can be an effective instrument for early-stage growth if you plan properly for dilution and repayment.

Now that you are familiar with the ins and outs of convertible notes, read other news, tips, and guides for finance teams on Rho’s blog here. 

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