What Are Convertible Notes and How Do They Work?

Businesses often require funding to initiate or expand operations. This article will explain convertible notes, a distinctive financial instrument used by companies to secure capital from investors, enabling growth and development.

Defining Convertible Notes

A convertible note is a hybrid financial instrument, structured as a debt obligation that can transform into equity. Investors provide a loan to a company, with the understanding this debt will convert into an ownership stake rather than being repaid in cash. This conversion usually occurs during a future equity financing round, such as a Series A funding. Convertible notes are commonly employed by early-stage companies and startups to secure capital.

This arrangement allows a company to receive funds without immediately determining a precise valuation, which can be challenging for nascent businesses. As a debt instrument, a convertible note is recorded as a liability on the company’s balance sheet until the conversion event takes place. Upon conversion, the debt is retired and replaced by equity, reflecting the investor’s new ownership position.

Key Components of Convertible Notes

A convertible note agreement includes several key terms.

Principal Amount

This represents the initial sum of money loaned by the investor to the company. This amount forms the basis of the debt that will eventually convert into equity or be repaid.

Interest Rate

This specifies how interest accrues on the principal. While interest is earned, it is typically not paid out in cash but accrues and is added to the principal, increasing the total amount that will convert into equity. Common interest rates can range from 5% to 12% annually, though variations, including notes with no interest, are possible.

Maturity Date

This is the predetermined point at which the loan becomes due if it has not yet converted into equity. If a conversion event does not occur by this date, the company may be obligated to repay the principal and any accrued interest, or the parties might renegotiate terms for an extension or forced conversion. Maturity dates commonly range from 12 to 24 months.

Valuation Cap

This sets a maximum company valuation at which the note can convert into equity, protecting early investors. For example, if a note has a $5 million valuation cap and the next financing round values the company at $10 million, the investor’s note converts as if the company were valued at $5 million. This means the investor receives shares at a lower price per share than new investors.

Conversion Discount

This rewards early investors by allowing them to convert their debt into equity at a price lower than that paid by new investors in a future equity round. For instance, if a note includes a 20% discount and new investors buy shares at $1.00 each, the convertible note holder converts at $0.80 per share. Both a valuation cap and a conversion discount may be included, with the conversion typically occurring at whichever term provides the investor with a more favorable outcome.

The Conversion Process

The transformation of a convertible note from debt to equity is typically triggered by a specific event, most commonly a “qualified financing round.” This refers to a subsequent equity funding round, such as a Series A investment, where the company raises a predetermined minimum amount of capital from institutional investors. Upon this triggering event, the accrued principal and interest from the convertible note are converted into shares of the company’s stock.

During conversion, the terms of the valuation cap and conversion discount are applied to determine the price per share at which the note converts. The investor will receive shares based on the lower of the price derived from the valuation cap or the discounted price from the new equity round. For example, if the valuation cap leads to a lower effective price per share than the discounted price, the cap will govern the conversion.

If a qualified financing event does not occur by the maturity date, the convertible note agreement outlines the next steps. The company might be obligated to repay the principal along with any accrued interest to the investor. Alternatively, the parties may agree to extend the maturity date, convert the note into equity at a pre-negotiated price, or pursue other arrangements.

Why Convertible Notes Are Used

Convertible notes serve as an effective financing tool for both companies and investors, particularly in the early stages of a business. For companies, especially startups, they offer a way to secure funding without the immediate need to establish a precise company valuation. Convertible notes allow companies to defer this detailed negotiation until a later, more established financing round.

This financial instrument also provides a faster and less complex alternative to traditional equity rounds. The legal documentation for convertible notes is generally simpler and less expensive to prepare, which can accelerate the fundraising process. This speed is beneficial for startups that require capital quickly to fund operations and growth initiatives.

For investors, convertible notes offer a strategic entry point into promising companies while deferring the valuation discussion. They provide a balance of downside protection, as the instrument is initially debt, and upside potential, through the conversion terms like valuation caps and discounts. These terms incentivize early investment by promising a more favorable conversion price than what later investors might receive.