Is a Convertible Note Debt or Equity?
Unpack the unique financial structure of convertible notes, clarifying their evolving role from initial debt to potential equity investment.
Convertible notes are financing instruments used primarily by early-stage companies to raise capital. These notes possess features of both debt and equity. Understanding how these instruments function is essential for both investors and founders. This article clarifies the dual nature of convertible notes, examining their debt and equity characteristics and conversion process.
Understanding Convertible Notes
A convertible note serves as a short-term debt instrument that includes an option for the loan to convert into equity rather than being repaid in cash. Startups use these notes as bridge financing, providing capital before a larger, more formalized equity funding round occurs. This approach allows companies to raise funds without needing an immediate valuation.
A convertible note includes a principal amount, an interest rate, and a maturity date. While interest accrues, it is added to the principal and converted into equity later, rather than being paid out in cash. The defining characteristic is the embedded conversion feature, which grants the investor the right to convert their debt into company shares under specified conditions.
Debt Characteristics
Initially, a convertible note functions as debt. A primary characteristic is the repayment obligation; the company is legally bound to repay the principal amount and any accrued interest to the investor if the note does not convert into equity by a predetermined date. This obligation provides downside protection for investors, as they have a claim on the company’s assets.
Convertible notes include an interest rate, which accrues over the life of the note, ranging from 2% to 8% annually. This interest is added to the principal. Convertible notes have a maturity date, set between 12 to 36 months, by which time the note must either be repaid or converted. Until conversion, the investor holds a creditor position, meaning their claim on the company’s assets is superior to that of equity holders.
Equity Characteristics
Despite their initial debt classification, convertible notes possess distinct equity-like qualities due to their conversion feature. The core aspect is the option or obligation for the note to transform into company shares. This conversion is triggered by specific events, such as a “qualified financing round” where the company raises a minimum amount of new capital from external investors.
Key terms influence the amount of equity an investor receives upon conversion. These include valuation caps and discounts. A valuation cap sets a maximum company valuation at which the note can convert, ensuring early investors receive a favorable share price. A discount provides a percentage reduction from the share price paid by new investors in the qualifying financing, ranging from 10% to 25%. These terms incentivize early investment.
The Conversion Process
The transition of a convertible note from debt to equity is initiated by specific triggering events. The primary trigger is a “qualified financing round,” where a company secures a new equity investment exceeding a predetermined financial threshold. This event signals a significant milestone for the startup, allowing the note to convert. If a qualified financing does not occur by the maturity date, some notes may automatically convert, or the company may be obligated to repay the principal and accrued interest.
Upon conversion, the principal amount of the note, along with any accrued interest, is exchanged for a specific number of shares. The calculation of these shares considers the valuation cap or discount rate, with the investor receiving the more favorable outcome. For example, a 20% discount means the noteholder converts at 80% of the new round’s share price, while a valuation cap limits the effective price per share. Once converted, the noteholder ceases to be a creditor and assumes the status of a shareholder, gaining the rights and risks associated with equity ownership. This conversion is reflected on the company’s balance sheet by reclassifying the obligation from a liability to equity.