Convertible notes allow investors to change debt into equity when certain events occur. Investors and founders use them in early-stage companies because the legal costs and complexities are lower than using other types of financing. These notes often offer better terms to earlier investors than to those who invest in later rounds. Read on if you want to know about this option for financing newly-created businesses.
What Terms Do Convertible Notes Contain?
Convertible notes contain provisions that help convert debt to equity on terms that both the founders and investors can understand. These are the typical terms of convertible notes:
- Interest Rate: This terms sets forth an annual interest rate that the convertible note generates.
- Term Length: Length of time until the convertible notes must be paid back or the company reaches its maturity event.
- Valuation Cap: The maximum valuation of the company when the debt turns into equity.
- Conversion Discount: This represents the discount offered to the holder of the convertible note.
How Do Convertible Notes Work?
Say an investor wants to put $10,000 into a new company using a convertible note with a $4MM valuation cap, a 4% interest rate, 2-year term, and a 15% conversion discount. A year later, the company raises equity from a VC at a valuation of $5MM and a price per share of 50 cents. What happens with the convertible note?
First, the holder of a convertible note gets a discount of 15%, so would pay 42 cents a share. And since the valuation cap is $4MM, each share has a value of 40 cents.
Since the loan accrued 4% interest, we value the loan at $10,400. And the note-holder uses the $10,400 to buy shares at 40 cents a piece. Therefore, the note-holder gets 26,000 shares of the company.
Why Use Convertible Notes?
Convertible notes provide an easy way for founders to raise money in a seed round. The legal complexities are fewer. Also, since the value of the company may not yet be clear or even easily determined, a convertible note offers a route for fund-raising that does not rely on doing the complex calculations to get to a valuation.
Do note that there are other options for this type of financing, including SAFE instruments. Before making a decision, discuss your options with a tax professional and an attorney. Nothing here is intended as legal advice, so get a lawyer.