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Convertible Notes: An Overview

by Samantha Ku

Convertible Notes: An Overview

Convertible notes can be a good source of funding for early-stage companies. Let’s take a closer look.

What is a Convertible Note?

Earlier, we explained the difference between debt and equity. A typical venture capital investment will often take the form of equity – for example, a Series A financing in which an investor will give the company money in exchange for a certain stake (say, 20%) in the company’s ownership, or equity.

A different way to structure an investment is through debt, which is a loan. In a convertible debt financing, the investor will lend a certain amount of money (say, $100,000) to a company, and the company will promise to pay it back, with interest. The legal document that contains the terms of this promise is called a “note,” which is why you’ll hear “convertible debt” and “convertible note” used interchangeably.

The difference between a convertible note and a plain old bank loan is that the loan in a convertible debt financing has the option to convert to equity (i.e., to an ownership stake in the company) upon certain triggers.

Convertible note financings are mostly used for very early-stage investments, usually before a Series A round. (The exception to this would be a bridge loan to tide the company over to the next equity financing, for example, between Series A and B.) The reason an early stage company might opt for convertible notes is to attract an initial cash infusion that will allow it to develop its product to the point where bigger investors will be interested in a full Series A round.

One major advantage that convertible debt has over an equity financing is that it saves a lot of negotiation, since it doesn’t force a valuation or share price on the company and effectively punts that discussion to the first equity financing round.

One major advantage that convertible debt has over an equity financing is that it saves a lot of negotiation, since it doesn’t force a valuation or share price on the company and effectively punts that discussion to the first equity financing round.

Important Terms

Discount: To attract its initial investors, a company will promise a reward for getting in early. This takes the form of a discount on participation in the Series A or some other “qualified financing.” For example, a 20% discount would mean that the convertible debt investor would pay 80 cents on the dollar to purchase shares in the Series A round compared to the full price the Series A investors will be paying.

Qualified financing: The company can set the threshold for a “qualified financing” that will trigger automatic conversion, whether it’s $1 million, $5 million, or more. Another possible trigger for conversion is the sale of the company, if it happens before the qualified financing. (Alternatively, the sale of the company could instead result in the repayment of the loan, including interest, with no conversion.)

Valuation cap: A cap can function as a pseudo-valuation of the company. The term sets a ceiling on the price the convertible debt investor will pay to purchase Series A shares. For example, if the cap is $5 million, the debt will convert to equity at a price that is the lower of: (a) $5 million divided by the number of total shares outstanding (all the equity in the company), or (b) the discounted price of 20% off the price per share the Series A investors are paying. If the discounted price goes above the cap, the convertible debt investor only has to pay the cap price.

Investors want a valuation cap to guard against future fluctuations in price. For example, imagine the future Series A round places the valuation of the company at $20 million, but the convertible debt investor thought the company would be worth $5 million when he invested. Even with the discount, the price per share will be higher than she had anticipated, and her debt will convert into a smaller stake in the company, which she will view as not adequately rewarding her for taking a risk at a very early stage.

Interest rate: It’s still a loan, so it has an interest rate. The interest accrued will also convert to equity. For example, take a $100,000 convertible note with a 5% interest rate and a term of one year. At the end of the one-year term, the total debt is $105,000. This $105,000 will be the figure that, divided by the share price (discounted or capped), will result in the total number of shares the convertible debt (and now equity) investor will own.

If you decide that convertible debt is the right structure for your company, check out 500Startups’ KISS form legal documents for convertible notes, which are now on Shake.

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