What Is the Meaning of a Convertible Note in Finance?

Startups often need funding before generating revenue, and one way they secure it is through convertible notes. These short-term loans from investors later convert into equity under specific conditions. They allow startups to postpone valuation discussions until a future financing round, offering flexibility for both founders and investors.

Key Terms

Convertible notes include financial provisions that shape their structure. Understanding these terms helps investors and startups assess potential benefits and risks.

Discount Rate

A discount rate lets investors convert their loan into equity at a lower price than future investors, rewarding them for early-stage risk.

For example, if a note has a 20% discount and the startup later raises funds at $5 per share, noteholders convert at $4 per share, giving them more shares for the same investment. Discount rates typically range from 10% to 30%, with the percentage negotiated based on the startup’s risk and expected conversion timeline.

Valuation Cap

A valuation cap sets a maximum company valuation at which a convertible note converts into equity, ensuring early investors receive a favorable price if the company grows quickly.

For instance, if a note has a $5 million valuation cap and the startup later raises funds at a $10 million valuation, noteholders convert as if the company were worth $5 million, resulting in a lower share price and a larger ownership stake. Unlike a discount rate, which provides a relative price reduction, a valuation cap can significantly increase investor returns if the company’s valuation rises sharply. Investors push for lower caps to maximize their upside, while founders prefer higher caps to limit dilution.

Interest Provisions

Convertible notes accrue interest, which is added to the principal before conversion. Unlike traditional loans, they usually do not require periodic interest payments.

Interest rates generally range from 4% to 8% per year. If an investor lends $100,000 at a 5% annual interest rate and the note converts after two years, the total conversion amount would be $110,250 with compounded interest or $110,000 with simple interest. Interest increases investor returns while also affecting the final ownership percentage when the debt converts into shares.

Conversion Events

A convertible note remains debt until a specific event triggers its conversion into equity. The most common trigger is a qualified financing round, where the startup raises a predetermined amount from new investors. If a note agreement sets a $1 million financing threshold, conversion occurs when the company raises at least that amount.

A change of control, such as an acquisition or merger, can also trigger conversion. In such cases, investors may receive an automatic payout or convert their debt into equity based on predefined terms. Some agreements offer investors a multiple of their original investment instead of conversion. For example, if a note specifies a 2x return in a change-of-control event, an investor who put in $50,000 would receive $100,000 upon acquisition.

Maturity dates also influence conversion. If a startup does not raise a qualifying financing round or undergo a change of control before the note matures, investors may have the right to convert their debt into equity at a predetermined valuation. This prevents indefinite delays while allowing startups to negotiate extensions or alternative repayment structures. If a note matures after 24 months without a financing event, investors might convert at an agreed-upon valuation set at issuance.

Repayment Options

While convertible notes are designed to convert into equity, repayment may be required if conversion conditions are not met. If a startup reaches the maturity date without a financing round or acquisition, it may need to repay the principal and accumulated interest. Some agreements allow for extensions, but investors may demand repayment if they see no clear path to growth.

If a startup has enough cash flow, it may choose to repay the note instead of issuing equity, avoiding dilution. However, this requires careful financial planning, as startups often operate with limited liquidity. Some agreements allow for partial repayment, where a portion of the debt is settled in cash while the rest converts into shares.

If a company struggles financially, investors may renegotiate repayment terms, such as extending the maturity date or lowering the interest rate. In cases of severe financial distress, investors might accept a discounted payoff to help the startup avoid bankruptcy.

Tax Factors

The tax treatment of convertible notes depends on whether they are classified as debt or equity under IRS guidelines. Typically, they are considered debt until conversion, meaning investors may need to report accrued interest as taxable income even if no cash payments are made. Startups, in turn, can deduct interest expenses, reducing their taxable income.

If a note lacks a fixed maturity date or repayment obligations, the IRS may reclassify it as equity, eliminating interest deductions and altering investor tax liabilities.

When conversion occurs, it is generally not considered a taxable event, as it is viewed as an exchange of one investment form for another. However, if the note includes a significant discount or valuation cap, the difference between the converted share price and fair market value could be taxable under Section 83 of the Internal Revenue Code. Investors should also consider capital gains tax implications, as the original note purchase date may not carry over, affecting eligibility for long-term capital gains treatment.