Convertible Note
QUICK ANSWER
A convertible note is a short-term debt instrument used primarily by early-stage startups to raise funding. Rather than repaying the loan with interest at maturity, the debt converts into equity, typically at a discount, during a subsequent funding round. It allows startups to raise capital quickly without needing to agree on a company valuation upfront.
In depth
Convertible notes have several key terms that govern how the conversion works. The discount rate gives the noteholder the right to convert their debt into equity at a lower price than what new investors pay in the next round, rewarding early investors for taking on more risk. The valuation cap sets a ceiling on the price at which the note converts, protecting investors if the company's valuation grows significantly before conversion. Interest accrues on the note during its term, but rather than being paid in cash, it typically adds to the principal that converts into equity.
Convertible notes became popular because they are faster and cheaper to execute than priced equity rounds, which require a formal valuation and more complex legal documentation. They are particularly useful at the pre-seed stage when it is difficult to determine a company's worth. However, founders need to be mindful of how multiple convertible notes with different caps and discounts can interact at the time of conversion, as the resulting dilution can be significant and sometimes surprising if not modeled out carefully in advance.
A worked example
Heading
Let's consider a real-world example of an early-stage startup that raises $200,000 from an angel investor using a convertible note before its first priced funding round.
The convertible note has the following terms:
Principal: $200,000
Annual interest rate: 6%
Valuation cap: $4,000,000
Discount rate: 20%
Maturity: 18 months
Eighteen months later, the startup raises a Series Seed round at a pre-money valuation of $6,000,000, with new investors paying $0.60 per share.
The angel investor can convert using either the valuation cap or the discount, whichever gives them a lower price per share (and therefore more shares).
Conversion using the valuation cap:
Cap Price per Share = Valuation Cap / (Shares Outstanding at Cap)
If the cap implies a price of $0.40 per share, the investor converts at $0.40.
Conversion using the discount:
Discount Price = New Investor Price x (1 - Discount Rate)
Discount Price = $0.60 x (1 - 0.20) = $0.48 per share
The cap price of $0.40 is lower than the discount price of $0.48, so the investor converts at $0.40 per share. With $200,000 in principal plus approximately $18,000 in accrued interest, the total amount converting is $218,000.
Shares Received = $218,000 / $0.40 = 545,000 shares
Had the investor simply invested in the Series Seed round at $0.60 per share, the same $218,000 would have bought only 363,333 shares. The valuation cap rewarded the angel investor's early risk with an additional 181,667 shares.