How Does a Convertible Note Work?

A convertible note is a financial instrument that begins as debt, similar to a loan, but can transform into equity, or ownership shares, in a company later. This hybrid nature makes it a unique tool for financing, particularly for early-stage businesses. It provides immediate capital while deferring the complex process of company valuation until a future investment round.

Key Elements of a Convertible Note

A convertible note agreement includes several fundamental components that define its terms and how it operates. These elements ensure clarity on the debt’s conditions and its transformation into equity.

Maturity Date

The Maturity Date specifies when the note’s principal and accrued interest become due if it hasn’t converted into equity. This period typically ranges from 18 to 36 months, sometimes up to five years. If conversion doesn’t occur by this date, the company must repay noteholders, or parties may agree to extend the date or convert at a pre-negotiated valuation.

Interest Rate

An Interest Rate is applied to the note’s principal, causing interest to accrue. This is typically simple interest, not compounded, often ranging from 2% to 10% annually. Accrued interest typically converts into equity with the principal, rather than being paid in cash. For example, a $100,000 note with a 5% annual interest rate accrues $5,000 in interest after one year, making $105,000 eligible for conversion.

Discount Rate

The Discount Rate provides noteholders a percentage reduction on the company’s valuation during a subsequent equity financing round. This compensates early investors for the increased risk of investing before a firm valuation. Common discount rates range from 15% to 25%, sometimes higher. For instance, if a note has a 20% discount and new investors buy shares at $1.00, the note holder converts at $0.80 per share.

Valuation Cap

A Valuation Cap sets a maximum company valuation for convertible note conversion into equity, regardless of a higher valuation in a future financing round. This protects early investors by ensuring they receive shares as if the company was valued at or below this cap, even if the company’s valuation significantly increases. Caps typically range from $2.5 million to $20 million, depending on the company’s stage. For example, if a note has a $5 million cap and the company raises funds at a $10 million valuation, the note converts as if valued at $5 million, allowing the noteholder to receive shares at a lower effective price than new investors.

Conversion Triggers

Conversion Triggers are specific events that cause the convertible note to transform from debt into equity. The most common trigger is a “qualified financing round,” defined as an equity financing round where the company raises a specified minimum capital from new investors. Other triggers include company acquisition or the note reaching its maturity date without qualified financing. These triggers are predetermined and outlined in the convertible note agreement.

Understanding the Conversion Mechanism

The conversion mechanism is the process by which a convertible note changes from debt into ownership shares. This transformation primarily occurs when a specific event, such as a qualified equity financing round, is triggered. The core of this mechanism involves applying either the discount rate or the valuation cap to determine the price at which the noteholder’s investment converts into equity.

When a qualified equity financing round occurs, the noteholder’s principal and accrued interest convert into shares. The conversion price, dictating how many shares the noteholder receives, is calculated based on the note’s terms. The investor typically benefits from whichever term, the discount rate or the valuation cap, results in a lower effective per-share price.

Conversion with Discount

One common conversion scenario involves the Conversion with Discount. This applies if the company’s pre-money valuation in the qualified financing round is below the valuation cap. The discount rate is applied to the new equity round’s per-share price. For example, a $105,000 convertible amount with a 20% discount, where new shares are priced at $1.00, results in a noteholder conversion price of $0.80 per share. This means the noteholder receives more shares than a new investor for the same amount.

Conversion with Valuation Cap

Alternatively, Conversion with Valuation Cap applies if the company’s pre-money valuation in the qualified financing round exceeds the valuation cap. The note converts as if the company’s valuation were equal to the cap. For instance, with a $105,000 convertible amount and a $5 million valuation cap, if a new equity round values the company at $10 million, the noteholder’s effective conversion price is based on the $5 million cap. This results in a capped price of $0.50 per share. At this price, the noteholder receives more shares than new investors.

The convertible note agreement specifies that the investor receives shares based on the calculation yielding the lower per-share price. If the discount results in a lower per-share price than the cap, the discount is used, and vice versa. This ensures the early investor receives the most favorable outcome for their initial risk.

If a qualified financing round does not occur by the maturity date, the convertible note agreement outlines alternative actions. The company may be required to repay the principal and accrued interest to noteholders. In some cases, the agreement might specify automatic conversion into equity at a pre-negotiated default valuation, though repayment is often the stated default. Companies and noteholders commonly negotiate an extension or different resolution to avoid immediate repayment if the company is not yet able to do so.

The Role of Convertible Notes in Startup Funding

Convertible notes serve a distinct purpose in startup funding, particularly for early-stage companies and their investors. They provide a streamlined approach to securing capital when traditional equity financing might be premature or complex. This financial instrument facilitates early investment by deferring the challenging process of assigning a precise valuation to a nascent business.

For startups, convertible notes offer a practical way to access capital quickly without immediate formal valuation. At early stages, accurately valuing a company is difficult due to limited operating history, revenue, or market position. Convertible notes bypass this, allowing founders to focus on product development and market traction rather than extensive valuation negotiations. This flexibility streamlines fundraising, enabling companies to raise smaller capital amounts from multiple investors more efficiently than a full equity round. These notes often bridge funding gaps between an initial idea and a larger, more structured equity financing round, such as a Series A.

For investors, convertible notes provide an opportunity to participate in promising startups early. By investing through a convertible note, they gain exposure to a company with significant growth potential, knowing their investment will convert into equity later. The discount rate and valuation cap provide structured incentives. The discount ensures early investors receive shares at a lower effective price than future investors, compensating them for higher risk. The valuation cap protects investors by setting a ceiling on the conversion price, meaning they benefit from potential significant increases in the company’s valuation.

Convertible notes are most commonly utilized in a startup’s pre-seed or seed funding stages. At these initial phases, companies develop foundational products or services and are not yet ready for a priced equity round. The simplicity and deferred valuation aspects of convertible notes suit these early investments. They facilitate smoother, faster capital infusion, aligning interests of founders seeking capital and investors looking for early entry into high-growth ventures.