How Convertible Notes Work: From Terms to Conversion

Convertible notes have emerged as a widely adopted financing instrument for early-stage companies seeking capital. This financial tool functions as a form of debt that can transform into equity under specific future conditions. Their hybrid nature allows startups to secure funding efficiently while offering investors a pathway to ownership.

Understanding Convertible Notes

Convertible notes are a type of short-term debt that converts into equity under predefined circumstances. Structured as loans, they bridge the gap between initial funding and a more substantial equity financing round. Startups and early-stage companies frequently utilize them to defer complex valuation discussions, as determining a precise company valuation can be challenging in nascent stages. This approach allows founders to access capital quickly, simplifying the initial funding process and often incurring lower legal and administrative costs compared to traditional equity rounds. The flexibility offered by convertible notes enables companies to focus on growth and achieving milestones before formal equity pricing occurs.

Key Terms and Features

Several fundamental components define how a convertible note operates, outlining the relationship between the company and its investors. Each term plays a specific role in governing the note’s eventual conversion into equity. Understanding these elements clarifies the mechanics of this financing vehicle.

The Maturity Date specifies when the convertible note becomes due and payable if it has not yet converted into equity. This period typically ranges from 18 to 36 months from issuance. If conversion does not occur by this date, the company is generally obligated to repay the principal amount along with any accrued interest.

An Interest Rate is applied to the principal amount of the convertible note, reflecting its debt characteristics. This rate usually falls within a range of 2% to 8% annually, though some notes may have lower nominal rates or no stated interest. The interest typically accrues and is added to the principal, increasing the total amount that will convert into equity or be repaid.

A Valuation Cap sets a maximum company valuation at which the note can convert into equity, providing a protective ceiling for early investors. If the company’s valuation at the time of a qualified financing round exceeds this cap, the investor’s conversion price is calculated based on the cap, not the higher valuation. For example, if an investor contributes $100,000 to a note with a $5 million valuation cap, and the company later raises a round at a $20 million valuation, the investor’s shares are priced as if the company was valued at $5 million, granting them more shares for their initial investment.

The Discount Rate provides early investors with a percentage discount on the per-share price paid by new investors in a subsequent qualified financing round. This discount rewards initial investors for taking on earlier risk. For instance, if a note has a 20% discount and new investors pay $1.00 per share, the convertible note holder converts at $0.80 per share. Convertible notes often include both a valuation cap and a discount rate, with the conversion occurring based on whichever term results in a lower price per share for the investor.

Conversion Triggers are specific events that cause the convertible note to transform into equity. The most common trigger is a “qualified financing round,” which refers to a subsequent equity investment round meeting a predefined minimum capital raise threshold. Other triggers can include a change of control or the achievement of specific business milestones.

The Conversion Process

The transformation of a convertible note from debt to equity typically occurs when a company completes a “qualified financing round.” This event, usually a significant equity fundraising, triggers the conversion as outlined in the note’s terms. The principal amount of the loan, along with any accrued interest, is then converted into shares.

To determine the number of shares the noteholder receives, the conversion price is calculated by applying either the valuation cap or the discount rate, whichever results in a lower price per share for the investor. For example, consider a $100,000 convertible note with a 5% accrued interest, a $5 million valuation cap, and a 20% discount rate. The total amount to convert is $105,000. If the company’s next qualified financing round values the company at $10 million with a per-share price of $1.00:

First, calculate the price per share based on the discount: $1.00 (1 – 0.20) = $0.80 per share. This would yield $105,000 / $0.80 = 131,250 shares. Next, calculate the price per share based on the valuation cap: if the pre-money valuation of the new round is $10 million and there are 10 million shares outstanding, the effective price per share for the noteholder, based on the $5 million cap, would be $0.50 ($5 million cap divided by 10 million outstanding shares). This would yield $105,000 / $0.50 = 210,000 shares. Since $0.50 is lower than $0.80, the investor receives shares based on the valuation cap, acquiring 210,000 shares in this scenario. This mechanism ensures the early investor receives a more favorable conversion price compared to new investors in the round, reflecting their initial risk.

Outcomes Beyond Standard Conversion

While the primary intent of a convertible note is conversion into equity during a qualified financing round, other scenarios can unfold if this trigger event does not occur. These alternative outcomes provide a comprehensive view of how convertible notes function.

If a convertible note reaches its maturity date without a qualified equity round, the note becomes due. The company is typically obligated to repay the principal amount plus any accrued interest to the noteholders. However, investors often prefer to extend the maturity date, sometimes for an additional year, rather than demanding repayment. This extension allows the company more time to secure equity financing, as forcing repayment could lead to financial distress and might not be in the investor’s best interest.

Another outcome arises if the company is acquired before the convertible note converts into equity. The terms of the convertible note agreement dictate how noteholders are treated. Common provisions include repayment of the principal and accrued interest, sometimes with a multiple of the principal. Alternatively, the note may convert into shares of the acquiring company, or noteholders might receive a cash payout as if they were stockholders immediately prior to the acquisition. The specific resolution depends on the negotiated terms, which aim to protect the early investor’s interest in a liquidity event.