Convertible notes, which are sometimes called convertible promissory notes, are short-term debt instruments that can be changed into equity at a set time.
Investors give founders notes that can be turned into shares of the company. At some point in the future, like during a future round of fundraising or a liquidation event (such as an acquisition, IPO, etc. ), these notes will turn into equity, or a piece of the company, usually in the form of preferred shares.
So, is a convertible note a loan or an ownership share? It’s a mix of the two. On a company’s balance sheet, convertible notes are shown as debt until they are turned into cash. When they are changed, they become shares of the company. As debt instruments, convertible notes also have an end date and can earn interest (two key differences with SAFEs, as outlined further down).
Convertible Note Terms
There are a few key parameters that must be kept in mind:
Discount Rate
This is the valuation discount you receive relative to investors in the subsequent financing round, which compensates you for the additional risk you took by investing earlier.
Valuation Cap
The valuation cap is an additional reward for taking on risk earlier on. It effectively caps the price at which your notes will convert into equity and, in a sense, provides convertible note holders with equity-like upside if the company takes off right away.
Interest rate
Convertible notes typically accrue interest because you are lending money to a company. However, rather than being paid back in cash, this interest accrues to the principal invested, increasing the number of shares issued upon conversion.
Maturity date
This is the date on which the note is due and the company must repay it.
Key factors when using convertible notes
investors should be aware that the use of convertible note financing at later stages can be seen as a bad sign. This is because it shows that the company was unable to raise a traditional priced funding round at a stage when valuations are common.
There are also some important things for founders to think about:
- How much of your own equity will you lose? If there is a big difference between the valuation cap on the convertible note and the valuation at the end of the priced equity round, the founder (and other future investors) could end up with less of a stake in the company than they thought they would.
- Will paying interest make it hard for you to get by? If interest payments have to be made, they could put a strain on cash flow and use money that could be better used to grow the company.
- Will a cap table that is too hard to understand turn off investors? A messy cap table could happen if there are too many convertible notes, especially if they all have different terms. This could stop people from investing in the future.
Can convertible notes be repaid ?
What happens if a conversion event doesn’t occur before a convertible note’s maturity date? Is the convertible note due?
Convertible notes must be repaid because they’re debt. This rarely happens, though. If a firm fails to obtain a priced equity round before maturity, it won’t have the finances to repay the note principal.
In this circumstance, convertible noteholders can:
- Repay. Noteholders could technically demand repayment. The company’s inability to do so could lead to bankruptcy. This alternative is rare because it doesn’t benefit noteholders or founders.
- Extend maturity. Noteholders will often extend the maturity date of the convertible note to offer founders additional time to raise a priced equity round. This extension may include renegotiating other agreements, such as reducing the valuation cap or increasing the discount rate.
- Note to equity at renegotiated valuation cap. Noteholders can convert to equity and become direct shareholders. Given the circumstances, they may renegotiate the conversion price to increase their shareholding portion.
Taxes and Convertible Notes
Convertible notes can be classified as debt or equity for tax purposes in the United States, depending on the facts and circumstances. Most convertible notes are treated as debt in practice, but companies should always consult a U.S. tax advisor when classifying these instruments for reporting purposes.
