What is a Convertible Note?
A Convertible Note is a form of short-term financing wherein the loan converts into equity rather than being repaid in cash.
Startups rarely qualify for traditional debt financing from banks and other senior lenders, meaning traditional bank loans are out of the question.
However, the conversion feature of hybrid securities such as convertible notes (i.e. debt → equity) and discounted pricing act as an incentive for investors to take on the added risk.
Table of Contents
- Convertible Note: Startup Financing Offering
- How Convertible Notes Work
- Convertible Note Financing Terms
- Convertible Note Caps (“Valuation Cap”)
- Benefits of Convertible Notes
- Risks of Convertible Notes
- Convertible Note Calculator – Excel Model Template
- Step 1. Pre-Seed Convertible Note Assumptions
- Step 2. Seed Stage Financing Terms
- Step 3. Post-Seed Stage Cap Table Build
Convertible Note: Startup Financing Offering
A convertible note is a frequent form of early-stage financing offered by startups to raise capital from investors.
Convertible notes are a type of loan issued by startups that convert into equity once a “triggering event” occurs.
Usually, the triggering event will be the startup’s next round of financing that exceeds an agreed-upon minimum threshold, i.e. “qualified” financing round.
The first investor money raised by startups is typically raised through the sale of convertible notes or perhaps a SAFE note.
The potential reward (i.e. the “upside”) from traditional bank loans is not adequate when applied to a startup with an uncertain future.
But for convertible note issuances, if a high-risk startup performs well, the post-conversion shares that the investors now hold are worth much more than the original loan principal, serving as an additional incentive (i.e. reward for risk) for the investors.
How Convertible Notes Work
Convertible note issuances are designed to convert into ownership in the issuer upon a subsequent round of qualified financing.
- Step 1 → Convertible Note Raise: The convertible noteholder lends capital to a startup – typically the first form of capital raised by the startup – ignoring the capital contributed by the founders and loans from friends and family.
- Step 2 → Accrued or Cash Interest: As part of the convertible note financing agreement, the noteholder earns interest while the loan is still outstanding, which is typically a short period (i.e. one to two years at most). But since the amount of cash on hand is minimal, the interest is ordinarily paid in the form of an accrual, i.e. the interest is added to the principal rather than paid in cash.
- Step 3 → Conversion: With traditional debt financing, the borrower is contractually obligated to repay the principal on the maturity date. But for a convertible note, the hybrid instrument converts into equity – with the conversion date contingent on the occurrence of a specified event, such as the subsequent round of qualified financing (i.e. the “triggering event”).
Convertible Note Financing Terms
Like traditional loans from banks and lending institutions, a convertible note is a contract with set terms that must be agreed upon between all parties involved.
Convertible notes must sufficiently “reward” the investor – considering these capital providers took on the most risk by investing in the startup the earliest – by setting terms giving them the option to buy discounted shares.
The most common terms are the following:
- Maturity Date: The agreed-upon date at which the note comes due – most often 12 to 24 months post-issuance – at which the security converts into equity or must be repaid in cash.
- Interest Rate: The coupon rate is typically lower than that of traditional loans due to the conversion feature and often accrues to the principal amount rather than being paid in cash.
- Valuation Cap: The “ceiling” value of the company used to determine the conversion rate, i.e. the upper maximum parameter.
- Discount Rate: The discount at which the note holder can convert their investment at a price per share lower than those paid by other investors (and usually ranges around 20%).
Convertible Notes Interest
Convertible notes are a hybrid between debt and equity. Like debt, interest (i.e. the coupon) on convertible notes must be paid periodically.
The lender will most likely be seeking the majority of their returns to stem from the equity upside rather than cash interest, so they typically will not charge high interest rates in cash to allow the startup with more breathing room.
The flexibility of convertible notes, such as avoiding the cash interest component, is a distinct feature – but it does not come without a price, e.g. the interest accrues to the principal amount instead of being paid in cash.
Convertible Note Caps (“Valuation Cap”)
The terms of the convertible note specify the valuation cap, which effectively functions as a “ceiling” at which their investment converts, i.e. the notes must convert at either 1) the cap or 2) the discount.
The established “ceiling” also gives the noteholder a “floor” concerning their ownership stake (%) post-dilution.
Because of the valuation cap, the noteholder can estimate whether the money will convert from loan to equity at or below a specified price per share set by the valuation cap’s parameters.
In the absence of a cap or discount, the notes would convert into the issuing company’s shares at the same price as the participating investors in the round. In such a case, there is no real incentive for the noteholder, i.e. no benefit to being an early investor.
Benefits of Convertible Notes
- Option to Raise Capital without Valuation: Startups often opt to use convertible notes to raise capital because the startup can obtain funding without establishing a specific valuation.
- Time to Mature: Early-stage companies can mature – i.e. adjust their business model and implement changes – using outside capital before determining the valuation at which the startup decides to raise capital in their next round of financing.
- Lower Interest Rate: Convertible notes represent a more straightforward, “cheaper” source of financing than traditional financing – which is primarily due to the equity-like upside of convertible securities. If applicable, mandatory cash payment obligations can be a significant drawback to the issuer, but the potential upside in returns on equity enables them to negotiate lower interest rates.
- Removal of Mandatory Repayment: In addition, another reason for raising funding by issuing convertible notes is the removal of the mandatory principal repayment at maturity, avoiding the risk of default.
- Accrued Interest Option: Given the uncertainty surrounding the startup’s future, agreeing to a regular schedule of cash interest payments is often unreasonable.
- Aligned Long-Term Interest (Flexibility): If the startup were to default and be liquidated, there is no real incentive for the investor (i.e. convertible note provider) to force the company to undergo liquidation – hence, the investor often gives the company the option to extend the note’s maturity or adjust the terms. While, of course, the adjustments are going to favor the investor, the startup gets the opportunity to continue operating in these cases.
Risks of Convertible Notes
- Deferred Interest: The downside to convertible notes is that the interest burden is deferred to a later date rather than being eliminated completely, i.e. “there is no free lunch.”
- Lack of Negotiating Leverage: The risk of convertible notes is determined by the terms of the financing, as these terms vary in each scenario – but the investor usually holds far more leverage in negotiating the terms of the funding than the borrower. This sort of lender-borrower dynamic is reasonable given how the convertible note investor is taking the risk in anticipation of the potential for outsized returns on a later date.
- Dilution Risk: In particular, the most substantial risk is placed on the current equity ownership due to the increased dilution from future investors. Protecting the convertible noteholders’ downside risk comes at the expense of cutting into the potential upside of the existing shareholders and future investors.
- Default Risk: The mandatory principal repayment could still be triggered under certain conditions – meaning the inability to repay can cause the startup to default.
Convertible Note Calculator – Excel Model Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. Pre-Seed Convertible Note Assumptions
Suppose a startup has raised $1 million in pre-seed convertible note financing.
Before accepting capital from the convertible noteholder, the startup is 100% owned by the two founders, who collectively own 10 million shares.
For simplicity, we’ll assume there is no interest paid on the convertible notes, neither on cash nor on an accrued basis.
The terms of the convertible note financing are as follows:
- Convertible Note Raise = $1 million
- Valuation Cap = $10 million
- Discount = 20%
To calculate the convertible price per share and the number of shares post-conversion, we will need the seed stage financing terms, so we’ll pause here.
Step 2. Seed Stage Financing Terms
The next round of financing, i.e. the triggering event for the convertible notes, is a seed stage financing round where $5 million is raised at a pre-money valuation of $20 million.
- Seed Stage Financing Raised = $5 million
- Pre-Money Valuation = $20 million
The seed investor price per share equals the pre-money valuation divided by the outstanding shares.
- Seed Investor Share Price = $20 million ÷ 10 million = $2.00
By dividing the seed funding raise by the price per share, we can calculate the number of shares owned by the seed investors as 2.5 million and the equity value as $5 million.
- Seed Investor Shares Issued = $5 million ÷ $2.00 = 2.5 million
- Seed Investor Equity Value = 2.5 million * $2.00 = $5 million
Returning to our convertible noteholder, the convertible price per share is the minimum between two values:
- Seed Investor Price Per Share × (Valuation Cap ÷ Pre-Money Valuation)
- Seed Investor Price Per Share × (1 – Discount %)
Using the “MIN” Excel function, the convertible price per share is thus $1.00, and the number of convertible shares is 1,000, which we calculated by dividing the convertible note raised by the share price.
- Convertible Note Share Share = $1.00
- Post-Conversion Shares Issued = $1 million ÷ $1.00 = 1 million Shares
Step 3. Post-Seed Stage Cap Table Build
Upon completion of the seed stage financing, the number of shares owned by each stakeholder is as follows.
- Founders = 10 million
- Convertible Noteholders = 1 million
- Seed Investors = 2.5 million
The equity value attributable to each is as follows:
- Seed Investor = $5 million
- Convertible Noteholders = $2 million
If there were no preferential terms for the noteholder, the equity value would have converted at the seed investor’s share price of $2.00, so the equity value would have only been $1 million.
But because of the convertible note’s structure, the noteholder’s investment increased to $2 million, reflecting a 100% return on investment (ROI) post-conversion.
- Return on Investment (ROI) = $2 million ÷ $1 million = 100%