What Are Convertible Notes?

Quick explanation of a common way startups get funded at the seed stage

Convertible notes are one of the most common ways that startups raise early-stage funding. Convertible notes technically are debt instruments (i.e., an “IOU” from a company to an angel investor) intended to convert to stock once a startup raises a larger round of financing — usually a “Series A” round from a venture capital firm.

Why Convertible Notes

Reasonable minds differ on whether equity deals or convertible notes are better. The primary advantage of convertible notes is that they avoid the need to set a valuation of the company. Early-stage startups are very difficult to value because there is so much uncertainty; indeed, many early-stage startups don’t have paying customers when they seek angel funding. Rather than founders and angel investors negotiating the unknown, convertible notes allow the parties to postpone valuation until a later round. Another advantage of convertible notes is that they involve less paperwork, and, consequently, less time and money spent on negotiation.

Two Key Economic Terms

I. Discount: the conversion discount is one of the ways angel investors are compensated for the risk they assume by investing early. The amount of the discount represents the return, on paper, that an angel investor would receive at the time a note converts.

For example, if a VC purchased shares in a Series A round at a price per share of $5, a note with a 20% discount would mean that the angels would get shares at $4/each. 20% is the most common discount.

II. Note Cap: the note cap is a value that represents a ceiling on the value of a company for the purpose of calculating angel investors’ ownership percentage. The note cap is not the value of the startup at the time of the note; instead, it’s a guarantee to the angel investors that they will not own less of the company than the sum of the notes divided by the cap in the event of a conversion.

To illustrate:

A. A startup issues $500K of convertible notes with a 20% discount, no cap and later raises a Series A at a $10 million post-money valuation. Assume the startup has 10 million shares so each share is worth $1. The discount means that the angel investors will receive equity at a price of $0.80/share and end up with 6.25% of the company (625K shares/10 million shares).

B. Same scenario, but the startup issues notes with a 20% discount and a $5 million note cap. At the time of the Series A, rather than using the $10 million valuation to calculate the angels’ ownership stake, we’ll use the $5 million note cap (the cap and discount are either/or: the angel investors get whichever is more favorable). Thus, the angels will now own $500K/$5 million, or 10% of the company (equal to 1,000,000 shares at $1/each).

Caps accomplish two things:

1. They are another manner of rewarding angel investors for the early risk they assume by guaranteeing them a minimum ownership percentage; and

2. They ensure that angel investors will support a startup seeking a high valuation at Series A because the angels know that a high valuation won’t radically reduce their ownership stake.