A Comprehensive Guide on How Convertible Notes Work

Daniel H. Weberman New York Business Attorney Portrait
Daniel H. Weberman
April 4, 2024

Convertible notes are a popular financing tool used by startups and early-stage companies to raise capital. They provide flexibility to both the company and investors, offering a unique structure that combines debt and equity features. In this comprehensive guide, we will delve into the world of convertible notes, exploring their definition, mechanics, benefits, drawbacks, and their role in startup financing. Whether you are an entrepreneur seeking funding or an investor looking to understand this investment instrument better, this guide is for you.

Understanding Convertible Notes

Definition and Basics of Convertible Notes

Convertible notes, also known as convertible debt or convertible securities, are a type of short-term debt instrument that can convert into equity or ownership stake in the company in the future. They are typically issued by startups and early-stage companies to raise capital during seed or angel financing rounds. Unlike traditional debt, convertible notes allow investors to convert their investment into equity at a later stage, typically during a future financing event, such as a Series A funding round or an acquisition.

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Convertible notes usually have a maturity date, which is the deadline by which the company must either repay the outstanding debt or handle the conversion of the notes. Additionally, these notes often come with a predetermined interest rate, which accrues during the note's term. However, unlike traditional debt, the primary objective of convertible notes is not to receive interest payments but rather to convert into equity.

The Importance of Convertible Notes in Business

Convertible notes play a crucial role in early-stage financing for both startups and investors. For startups, convertible notes offer a streamlined and efficient way to raise capital without the need to determine an immediate valuation for the company. Since valuing a startup can be challenging, especially at an early stage, using convertible notes allows the company to postpone the valuation process until a future financing round or milestone event.

For investors, convertible notes provide an opportunity to invest in promising startups without the need to negotiate intricate terms and valuations. By investing through convertible notes, investors can secure their place in the capital structure of the company while deferring the determination of its value to a later date. This flexibility can be particularly advantageous in situations where the company's valuation is expected to increase significantly in the near future.

The Mechanics of Convertible Notes

Key Elements of Convertible Notes

Convertible notes typically include several key elements that govern the terms and conditions of the investment. These elements are essential for both the company and the investors to understand the rights, obligations, and potential outcomes associated with the convertible note investment. The key elements of convertible notes include:

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  1. Conversion Discount: This is a discount applied to the conversion price of the notes upon conversion into equity. It incentivizes early investors by allowing them to convert their debt into equity at a lower price than future investors in subsequent funding rounds.
  2. Conversion Cap: A conversion cap sets the maximum valuation at which the convertible notes can convert into equity. It protects the early investors from excessive dilution if the company's valuation skyrockets in subsequent financing rounds.
  3. Valuation Cap: Similar to the conversion cap, the valuation cap sets the highest valuation at which the convertible notes can convert. It ensures that early investors are rewarded for taking on the risk of investing in the early stages of the company.
  4. Interest Rate: Convertible notes may accrue interest at a predetermined rate during the note's term. The interest is typically payable upon conversion or maturity, providing an additional potential return for the investors.
  5. Conversion Trigger: The conversion trigger is the event or milestone that triggers the automatic conversion of the notes into equity. This is usually a future financing round, such as a Series A funding, where a minimum amount of capital is raised.

How Convertible Notes Convert into Equity

Conversion of convertible notes into equity typically occurs when a specific event or trigger specified in the convertible note agreement is met. This trigger event is usually a subsequent financing round or a liquidity event, such as an acquisition or an initial public offering (IPO). Once the conversion trigger is met, the outstanding principal, plus any accrued interest, automatically converts into equity based on a predetermined conversion price or formula.

The conversion price is typically determined by dividing the company's valuation at the subsequent financing or liquidity event by the outstanding convertible notes' debt and accrued interest. For example, if the company is valued at $10 million at the Series A funding round and has $1 million in outstanding convertible notes, the conversion price would be $10 million divided by $1 million, resulting in a conversion price of $10 per share.

Upon conversion, investors receive shares of the company's preferred stock or, in some cases, common stock. The conversion ratio is calculated by dividing the total investment amount by the conversion price, determining the number of shares the investor is entitled to receive.

Benefits and Drawbacks of Convertible Notes

Advantages of Using Convertible Notes

Convertible notes offer several benefits over traditional equity financing for both startups and investors. Some of the advantages include:

  • Simplified Valuation: Convertible notes allow startups to raise capital without undergoing the complex process of determining an immediate valuation.
  • Ease of Execution: Issuing convertible notes involves fewer legal and regulatory requirements compared to equity financing, making it relatively quicker and simpler.
  • Flexible Terms: Convertible notes offer flexibility in terms of interest rates, conversion discounts, and other terms, allowing startups to structure the investment to suit their needs.
  • Investor Incentives: The conversion discount and other features of convertible notes provide incentives to early investors, encouraging them to invest in the company's early stages.

Potential Risks and Downsides

While convertible notes have their advantages, it is essential to consider the potential risks and downsides associated with this financing instrument. Some of the risks include:

  • Dilution: Converting convertible notes into equity can lead to dilution for existing shareholders, including founders and employees.
  • Uncertain Valuation: Since convertible notes delay the valuation process, there may be uncertainty regarding the company's value and the conversion terms during subsequent financing rounds.
  • Interest Payments: The accrued interest on convertible notes can create financial burdens for the startup, especially if the company is not generating sufficient cash flow or profits during the note's term.
  • Conversion Risk: In some cases, there may be a risk that the conversion will not occur if the subsequent financing round does not reach the required threshold or if a liquidity event does not materialize.

Navigating Convertible Note Agreements

Essential Terms in a Convertible Note Agreement

When entering into a convertible note agreement, it is crucial to understand the terms and provisions included in the agreement. Some of the essential terms to consider include:

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  • Conversion Terms: This includes the conversion price, conversion discount, valuation cap, and other terms that dictate how the notes convert into equity.
  • Interest Rate: The interest rate and terms related to interest payments, such as whether the interest is compounded or simple, should be clearly defined.
  • Maturity and Repayment Terms: The maturity date and repayment terms specify when the convertible notes should be repaid, either through conversion or actual repayment.
  • Events of Default: The agreement should outline the events or circumstances that would trigger a default, potentially leading to accelerated repayment or other consequences.
  • Amendments and Governing Law: The ability to amend the agreement, as well as the jurisdiction and laws governing the agreement, should be clearly defined.

Negotiating a Convertible Note Agreement

During the negotiation process, both the company and the investors should consider their respective interests and objectives. Companies may seek to protect existing shareholders and employees from dilution, while investors may focus on securing favorable conversion terms and rights. Some areas that often require negotiation include:

  • Conversion Terms: Investors may negotiate for a lower conversion price, a higher conversion discount, or a more favorable valuation cap.
  • Investor Rights: Investors may seek additional rights, such as information rights, registration rights, or preemptive rights, to protect their investment and maintain control.
  • Protections and Covenants: Companies may offer certain protections to the investors, such as anti-dilution provisions or change of control provisions, to provide downside protection.
  • Warrant Coverage: Investors may negotiate for warrants or additional rights to purchase equity in the company, providing potential upside and additional return on investment.

The Role of Convertible Notes in Startup Financing

Why Startups Choose Convertible Notes

Startups often choose convertible notes as a financing option due to their numerous advantages and flexibility. Some of the reasons why startups opt for convertible notes include:

  • Valuation Postponement: Convertible notes allow startups to postpone the valuation process until a later financing round, avoiding the need to negotiate a valuation at an early stage.
  • Streamlined Fundraising: The simplicity and speed of executing convertible notes make them an attractive option for startups seeking to raise capital quickly.
  • Mitigating Risks: By using a convertible note structure, startups can reduce the risk of setting an excessively high valuation, which could lead to difficulty in future financing rounds.
  • Attracting Investors: The unique features of convertible notes, such as conversion discounts and valuation caps, can attract early-stage investors seeking favorable terms and potential upside.

Convertible Notes vs. Traditional Equity Financing

While convertible notes are a popular financing vehicle for startups, they are not the only option available. Traditional equity financing, such as issuing shares of stock, also has its advantages and considerations. Some of the key differences between convertible notes and traditional equity financing include:

  1. Valuation: Traditional equity financing requires determining an immediate valuation, whereas convertible notes allow postponement of the valuation process.
  2. Legal Complexity: Equity financing often involves more complex legal and regulatory requirements than convertible notes, which can impact the speed and cost of the fundraising process.
  3. Ownership and Control: Equity financing entails issuing shares of stock, which dilutes existing ownership and may result in changes in control, whereas convertible notes may convert into equity at a later stage.
  4. Investor Protection: Convertible notes may include features that provide downside protection and additional safeguards for investors compared to traditional equity financing.

In conclusion, convertible notes offer a flexible and attractive financing option for startups and early-stage companies. By allowing for the conversion of debt into equity at a later stage, convertible notes provide a streamlined approach to raising capital, while deferring the valuation process. However, as with any investment instrument, convertible notes come with benefits, drawbacks, and unique considerations that both companies and investors should carefully evaluate. Understanding the mechanics, terms, and role of convertible notes in startup financing is essential for navigating the complexities of early-stage fundraising successfully.

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