Convertible Note

This article will answer all your questions about convertible notes, what they are, how they are compared to convertible bonds and preferred stock and informational videos on how they work as well.

What Is A Convertible Note?

A convertible note is a short-term debt that converts into equity. In other words, investors loan money to a startup as its first round of funding; and then rather than get their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of the note.

Convertible notes are popular with startup companies. It helps them raise funds from investors who are willing to take a risk on an untested company.

As a reward, these investors may get to share in the company’s success. If the company does well, the shares the investors ultimately receive as payment will be worth more than the original loan.

How Do Convertible Notes Work?

Convertible notes can be a simpler source of financing for startups compared with a traditional round of financing. There are a few steps into the life cycle of a convertible note and how they work.

Typically, an investor will provide an early-stage startup in need of capital with a loan (with repayment terms in the ballpark of a standard short-term loan, usually a year or two), along with repayment terms. This is the “convertible note.” The note will include a due date at which time it’s mature and the balance will be due, along with interest.

If, however, the maturity date reaches and your startup has not yet converted the note to equity, the investor can either extend the convertible note’s maturity date or call for the actual repayment of the note.

Equity vs. Debt vs. Convertible Notes

Below is a table for your understanding of the comparison between some of the terms and regulations regarding a comparison between equity, debt and convertible notes.

EquityDebtConvertible Note
OwnershipYesNoNo, while convertible debt is outstanding, then Yes after it converts to equity
Voting RightsYesNoNo, while convertible debt is outstanding, then Yes after it converts to equity
Repayment of CapitalNo repayment until sale of companyRepayment on fixed scheduleRepayment on maturity, or converted to equity and no repayment until the sale of the company
Payment of Dividends or InterestDividends accrued, and paid out upon sale of companyInterest paid on fixed scheduleInterest accrued, and either repaid on maturity or converted to equity

The video below summarises all you need to know about how convertible notes work along with other funding methods for additional information and comparison to a convertible note.

What Is A Convertible Note?

Other methods and alternatives of funding your startups are listed in our Startup Capital article.

Convertible Note vs Preferred Stock

Before we compare a convertible note with preferred stock, let us briefly look into the definition of what preferred stock is.

There are a lot of complicated definitions of preferred stock. Here is a simple and summarised version. Preferred stock is a type of capital stock issued by corporations. Every year, the holders of the preferred stock are to receive their dividends before the common stockholders are to receive a dividend.

A preferred stock, like common stock, pays a dividend but has a higher rank than common stock should a company face liquidation. Preferred stockholders also receive dividend payments before common shareholders in the case of liquidation.

Convertible notes are loans that convert into the preferred stock that is sold in a subsequent equity round of investment.

In comparison, the positive thing about a convertible bond is that it allows individuals to participate in the capital appreciation of the company's stock. It is understood that if the stock is not doing well, there's no need to convert. In the meantime, you're still collecting periodic interest payments from the bond.

While a preferred stock offers you the peace of mind of receiving a dividend, you don't receive any capital appreciation on the shares if the company does well.

Valuation of A Convertible Note

In order to find out the valuation of convertible notes, its essential to understand the relationship between interest rates and the value of the note.

Let us go through a few examples to understand how a convertible note is valued. We start by singling out the two most important variables associated with a convertible note – the valuation cap and discount rate.

A hypothetical example is taken from Seed Invest, In this example, we can assume that a company has raised a seed round by issuing a convertible note with a $4M valuation cap and no discount before its Series A round at a $12M pre-money valuation and a $10 price per share. In order for us to calculate the valuation cap adjusted price per share for the convertible noteholders, we are to divide the valuation cap on the note by the pre-money valuation of the subsequent round. The answer is then to apply to Series A price per share.

This example works out to $3.33 per Series A share for convertible note holders. Dividing a hypothetical $10,000 investment by that $3.33 per share price would grant the seed investor approximately 3,000 shares. Note that an investor investing that same $10,000 directly in the Series A round at $10 per share would only be issued 1,000 shares.

Convertible Note

In the second scenario, the company is raising its subsequent round at only a $4.5M pre-money valuation and the same $10 per share price. The 20% discount would again result in an $8 per share price for noteholders. Because dividing the $4M valuation cap by the $4.5M pre-money valuation and applying that to the $10 share price results in a higher $8.89 per share price for seed round investors, in this case, it would be the discount that drives the conversion.

**Please note that this is not a guaranteed outcome and merely a hypothetical example of how convertible notes work for conceptual understanding. Real-life outcomes may differ.

What Investors Look For In Convertible Notes

Companies with poor credit ratings often issue convertibles in order to lower the yield necessary to sell their debt securities. The investor should be aware that some financially weak companies will issue convertibles just to reduce their costs of financing, with no intention of the issue ever being converted. As a general rule, the stronger the company, the lower the preferred yield relative to its bond yield.

At the point when cash is tight, and stock costs are developing, even very credit-commendable organizations will give convertible protections with an end goal to lessen their expense of getting capital. Most guarantors trust that if the cost of their stocks rises, the bonds will be changed over to basic stock at a value that is higher than the current normal stock cost.

Pro's and Con's of Convertible Notes

If you are considering a convertible note for your startup, be sure that you are aware of the advantages and disadvantages as well. A few of the advantages are listed below:

  • The major benefits of using convertible notes as a method of funding are their simplicity, speed, and avoidance of the need for a valuation. With a simple contract, your startup receives the funding it needs and the valuation is able to be pushed out to a time that makes more sense for your business.
  • Convertible note financings are simpler to document from a legal perspective. This means that they are generally less expensive from a legal perspective and that the rounds can be closed more quickly. The reasons for this are pretty simple, being that the company and the investors are putting off some of the trickier details to a later date. In most equity financings, numerous corporate documents need to be updated to close the round such as certificates of incorporation, operating agreements, shareholder agreements, voting agreements, and various other items. All of this adds to the time and expense of completing a round of equity funding.

As for the risks, they are as follows:

  • The major downside of a convertible note is that you will eventually be giving up some control over your business. When the convertible note comes due, the investor will be granted equity in your business. If you’re not ready to split ownership of your business with outside parties, this is not the right financing option for you.
  • The other area of risk is in relation to the cap. There is the risk that you raise money significantly below your cap and therefore give up a large percentage of the equity to initial investors.

To Summarise

Ultimately, the purpose of a convertible note is to defer valuing the startup until it has matured and proven itself further, thereby allowing the startup to generate more data points and reach certain metrics that will allow investors to arrive at an appropriate valuation in the future.

Startups and investors choose to use convertible notes because they’re simple and fast. Since convertible notes are a type of debt, they give you the ability to avoid the complications of a priced round where you actually issue shares of stock.

Make sure you know what happens if you do not end up raising additional equity, and also what happens if things go spectacularly well and you are able to raise additional equity far above the valuation cap (if that is part of the note).

The infographic below summarises the process of how a convertible note works in chronological order.

convertible note

Key Terms

Some key terms that are associated with a convertible note should be noted and remembered:

  • Maturity Date. The date at which the note comes due, usually 12 to 24 months after issuance, at which point it either converts to equity or must be paid back in cash
  • Valuation Cap. The upper limit on the value of the business that’s used to determine the conversion rate
  • Discount Rate. A bonus, which allows the note holder to convert their investment (plus interest) at a price lower than that paid by later investors; these typically range from 10% to 35%.
  • Interest Rate. This is usually lower than a traditional business loan and accrues over time rather than being paid monthly. If the note converts into equity, the investor will never receive cash interest and will instead receive a larger ownership stake.

References

Everything You Need To Know About Convertible Note

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Written by Meerat Qureshi

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