What is a Convertible Note and How does it work?

Speed and simplicity are key in early-stage startups, as is access to capital. Convertible notes can be a fast, straightforward way for founders to raise money during the early stages of their company lifecycle.

What is a Convertible Note?

A convertible note is a form of short-term debt financing used in early-stage startups. It includes a right for the debt to be converted into equity under specified conditions in the offering documents. One condition might be when early-stage companies reach a defined valuation, and another might be at a specified maturity date. Convertible notes terms generally carry an interest rate that gets factored in during the conversion from debt to equity.

Putting it simply, a convertible note can be used for an investor to loan money to a startup, with the expectation that they will be repaid with equity in the company. This type of funding provides a startup company flexibility that a traditional business loan cannot provide.

How Do Convertible Notes Work?

A startup may use a convertible note to raise capital by sourcing loans from seed investors. The repayment period is often similar to a standard short-term loan, say one year, two years, or perhaps up to five years. The terms will include a date when the loan falls due, as well as include the defined interest rate.

There is usually an implicit understanding that the preferred outcome is for the convertible note not to be repaid in cash, but rather by equity in the form of stock, ideally at a discount to the applicable market rate at the time of conversion. That being said, a holder of a convertible note has the right to ask for repayment in cash if the maturity date is reached before the startup can raise another funding round. Another option for the investor may be to choose to extend the maturity date of the convertible note.

The objective of a convertible note is (hopefully) for the startup to perform well on a strong growth trajectory, which can add value for the investor when it comes to a priced round with a formal valuation as part of a capital raise. Typically, the goal for an investor is not to get their loan repaid but rather to convert their debt into heavily discounted stock in a growing, valuable company. As a debt investment, early investors are taking a considerable risk in an unproven, early-stage company. However, convertible note holders should understand the pros and cons that are attached to these investment opportunities. Often, temporary debt investments can be a good way to earn equity in the company, and see potential positive returns.

Why Startups Might Use Convertible Notes

In the early stages of a startup, obtaining a valuation can be a complex, time-consuming, and expensive process which can have serious future implications. The challenging valuation process can be an inhibitor to raising capital through an early equity round. This is where convertible notes can be an attractive option because they do not require a valuation to set up. The founder and the investor simply agree to the terms of the loan, which gives the investor the right to convert their debt to equity in a future funding round once the company has progressed sufficiently to obtain a realistic valuation. This type of debt security allows startup companies to hit the ground running without the need to navigate through the complex valuation process. Convertible notes can also help raise subsequent equity financing in the future by giving startups the initial financial momentum they need to demonstrate successful key performance indicators.

Why Established Businesses Might Use Convertible Notes

While frequently used, convertible notes are not only for startups. Established businesses may also use convertible notes, even if they have previously raised capital. One reason for this is they might be going through a difficult time and need some capital, but they do not want to raise funds via a priced equity round. A priced equity round may cause the valuation to be lower than a previous funding round and this could be perceived negatively by the market. Existing equity investors can also get concerned because this could trigger a need for them to write down the value of their investment in the company.

Other Debt Securities Available to Investors

Other types of debt securities are available to investors such as (e.g. U.S. Treasury bonds, U.S. government bonds, or corporate bonds), a Simple Agreement for Future Equity (“SAFE”) , or venture debt . Each of these options have pros and cons, and their suitability for particular investors will depend on an investor’s own personal circumstances and objectives.

Debt financing is rising in popularity, so is often used instead of a convertible note.

Benefits of Convertible Notes

Convertible notes typically are simple and fast because they do not require a great deal of setup or company valuations. A standard term sheet is often used, which can facilitate a quick pathway to capital raising.

For investors, the hybrid nature of convertible notes provides flexibility in the investment. The debt nature of the note can provide some protection in the event the company does not do well, and the equity nature of the note allows them to potentially participate in the upside if the company does do well. Other potential benefits to equity financing include the interest received, discounts on the stock price, and the valuation cap on conversion. If a company performs well and achieves a high valuation in a priced round, the conversion cap on a convertible note could allow investors to convert their debt to equity at below the market rate.

Downsides of Convertible Notes

Downsides to convertible notes include rapidly accumulating interest, “shadow ownership,” and “liquidation overhang,” which are discussed below.

Convertible notes accrue interest, which represents an additional cost to the company and can adversely affect investors. Interest can accrue rapidly, so it is important for the founders and investors to be aware of that. Investors do not always look at the balance sheet, especially the liability side-it is critical to pay attention to the debt showing on the balance sheet. This is particularly important if there are senior secured loans in place because these can be potentially risky if they are held by aggressive investors willing to apply leverage to achieve outcomes to their own advantage.

The term “shadow ownership” refers to a lack of clarity around the percentage distribution of company ownership in the event that all outstanding debt was converted to equity. It can be a problem because it may not be immediately clear who is entitled to what, with various potential outcomes depending on the valuation and the terms associated with debt-to-equity conversions, particularly if they have been issued at different times on different terms.

Liquidation overhang refers to an imbalance between the amount of stock a convertible note holder receives compared to what a new investor pays for the stock, due to the effect of stock discounts and the difference between the valuation cap and the market value of a priced round. The bigger the difference between the valuation cap and the market value, the bigger the liquidation overhang. With valuation caps and liquidation preferences, the holders of preferred stock or convertible notes (with stock discounts and/or valuation caps in play) must be paid before the holders of common stock such as employees in case of a liquidation event . Common stockholders might be left with nothing if the company is in liquidation overhang and the value of a liquidation event (such as a sale or merger) does not exceed that amount.

It is relevant to consider that convertible notes have been around for a long time and may be seen by some to be out of favor in the current venture capital environment. SAFE arrangements are more common now, and venture debt is also rising in popularity.

Common Terms for a Convertible Note

Convertible note terms will be documented in a Term Sheet or Note Purchase Agreement. Some investors focus only on headline items such as interest rate, maturation date, valuation cap, and discount, but it is important to also pay attention to other terms applicable to the convertible note. The following list provides context on some terms that may apply to a convertible note.

1. Valuation Cap: The agreed maximum company value that will be used when converting the convertible note to stock.
2. Discount: The agreed discount from the Valuation cap in a priced round. This often ranges from 0% to 25%.
3. Maturity Date: The agreed date when the convertible note matures. The note duration may range from about 18 months to about five years. Investors often prefer longer periods because it allows more time to monitor how the company is progressing.
4. Interest Rate: The interest rate that applies to the convertible note, often ranging from 3% to 9% per annum. Note the payment of interest is in most cases payable at maturity, meaning interest payments are deferred until the note matures or is converted.
5. “Change of ownership” provisions: Outlines what happens if the company goes through a change of ownership and what criteria must be met to qualify as a change in ownership. This ensures that the founders and the investors know the terms that must be satisfied to trigger the provisions of the convertible note which are dependent on a change in ownership.
6. Representations and warranties of investors: Statements of fact, commitments, and warranties from the investor in relation to the convertible note agreement, such as confirmation of investor status, confidentiality, lock-up agreements, or acknowledgment of investment risk.
7. Representations and warranties of company: Statements of fact, commitments, and warranties from the company in relation to the convertible note agreement, such as the company’s structure and operation, authorization to act, disclosure of any litigation proceedings, or confirmation of the validity of any stock issuance.
8. Option to convert at the Valuation cap price per share: This protects the holder of the convertible note if the company is doing well and the valuation exceeds the Valuation cap, but a pre-defined conversion event has not been triggered.
9. Computation of the “pre-money” value per share: Defines the method for calculation of the pre-money value per share, including all outstanding stock.
10. Event of default: Outlines the events under which the company is in default of the terms of the convertible note.

Conclusion

Convertible notes have been around for a long time and have now been supplemented by additional capital raising structures such as SAFEs and venture debt. Convertible notes can still be a fast, simple option for companies seeking capital and investors seeking opportunities for investing in startups.

If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the platform.

This article is for informational purposes only. We do not provide legal, financial, or tax advice and investors should consult their advisors prior to making any investment. As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.

Originally published at https://www.propelx.com on March 25, 2022.