What Is a Convertible Promissory Note?

A convertible promissory note functions as a financial instrument used by early-stage companies to raise capital. It begins as a debt, a loan from an investor to a company. This loan, however, carries the potential to transform into equity, or ownership shares, in the company at a future date. Companies often favor these notes because they provide necessary funding without requiring an immediate valuation of the business, a process that can be complex and time-consuming for young ventures.

Core Components

A convertible promissory note combines characteristics of both debt and equity, making it a hybrid security. This dual nature allows for flexibility in early-stage financing.

The promissory note aspect establishes the initial loan from the investor to the company. This includes the principal amount, which is the original sum of money invested. An interest rate is also applied to this principal, with common rates typically ranging from 2% to 12% per year. This interest usually accrues over time and is not typically paid in cash prior to conversion, instead adding to the total amount that can convert into equity.

A maturity date specifies when the loan becomes due if it has not converted into equity. These dates commonly fall within 12 to 36 months from the note’s issuance. This deadline provides a defined period for the company to achieve growth milestones, ideally leading to a subsequent financing round. Should the note not convert by this date, the company is obligated to repay the principal and any accrued interest.

The convertible aspect provides the investor with the option to convert the debt into equity, rather than receiving cash repayment. This embedded feature allows early investors to participate in the company’s growth and potential upside. The initial loan, plus any accumulated interest, can be exchanged for ownership shares. This structure appeals to investors by offering the security of a debt instrument while retaining the potential for significant returns associated with equity ownership.

Understanding the Conversion Process

The conversion of a convertible promissory note from debt into equity typically occurs when specific events are triggered. The primary trigger for conversion is often a “qualified financing round.”

A qualified financing round refers to a subsequent equity funding round where the company raises a predetermined minimum amount of capital. This threshold, commonly set at $1 million or more, aims to ensure that the company has achieved a significant level of validation and growth before the conversion takes place. This event establishes a market-based valuation for the company, which determines the conversion price.

Conversion can be either automatic or optional, depending on the terms negotiated in the note. Most commonly, conversion is automatic upon the occurrence of a qualified financing event. In some agreements, investors might have the option to convert under specific conditions, though this is less frequent. Once a conversion trigger event occurs, the mechanics of conversion determine the number of equity shares the investor receives.

The total amount converting into equity includes the original principal amount of the loan and any accrued interest. This sum is then divided by the conversion price per share, which is calculated based on the terms of the qualified financing round, often adjusted by specific financial provisions. This calculation yields the number of shares the investor receives, transforming their debt investment into an ownership stake.

If a conversion trigger event does not occur by the maturity date, various scenarios can unfold. The company may be obligated to repay the principal and accrued interest to the noteholders. However, since early-stage companies are often cash-poor, this repayment rarely happens in practice. Instead, parties often negotiate an extension of the maturity date, giving the company more time to secure a qualified financing round. Alternatively, the terms might be renegotiated, leading to a conversion at a pre-determined valuation or a different type of security.

Key Financial Provisions

Convertible promissory notes include specific financial provisions that influence their conversion into equity. These clauses are designed to protect and incentivize early investors. Understanding these terms is important for comprehending the financial implications of such an investment.

A valuation cap sets an upper limit on the company’s valuation at which the note converts into equity, regardless of the actual valuation achieved in the qualified financing round. This provision ensures that early investors receive more shares if the company’s valuation significantly increases by the time of the qualified financing. For example, if a note has a $10 million valuation cap, but the company raises a Series A round at a $20 million valuation, the investor’s note converts as if the company were valued at $10 million, resulting in a lower price per share and more shares. This mechanism rewards early investors for the heightened risk they undertake.

A discount rate offers the investor a reduction on the price per share paid by new investors in the qualified financing round. Common discount rates range from 10% to 35%, with 20% being a frequently observed percentage. For instance, if new investors pay $1.00 per share and the note includes a 20% discount, the convertible note holder converts at $0.80 per share. This discount compensates early investors for their initial risk and for providing capital when the company’s future was less certain. When both a valuation cap and a discount are present, the note converts based on whichever term yields a lower price per share for the investor, maximizing their shareholding.

Interest accrual on the note means the accrued interest is added to the principal amount before conversion. This increases the total amount converting into equity. From a tax perspective, this accrued interest is considered interest income to the lender, even if it converts to equity. Companies provide a Form 1099-INT to investors annually for this accrued interest.

If no qualified financing or other conversion event has occurred by the maturity date, the note becomes due and payable. Parties may negotiate an extension of the maturity date. In some cases, the note may convert into equity at a pre-determined valuation upon maturity, or the company might be required to repay the principal and accrued interest in cash. This incentivizes the company to achieve a financing round before the maturity date to avoid potential repayment obligations or unfavorable conversion terms.