What is a Convertible Note?

Convertible notes are one of the most common investment instruments when it comes to early-stage venture financing.

According to the Angel Capital Association’s 2020 Angel Funders Report, 37% of angel deals were done using convertible notes in 2019.

Given the prevalence of these instruments, it behooves investors to know how they work. In this guide, we’ll cover the mechanics of convertible notes, the benefits and considerations when using them, as well as how they compare to SAFEs.

What is a Convertible Note?

Convertible notes—sometimes called convertible promissory notes—are short-term debt instruments that convert to equity upon a predetermined conversion event.

Investors offer founders convertible notes in exchange for equity in the company. At some later point, such as a future fundraising round or liquidation event (acquisition, IPO, etc.), those notes will convert to equity (in other words, an ownership stake in the company)—usually in the form of preferred shares.

So, is a convertible note debt or equity? It’s a little of both. Convertible notes are recorded as debt on the company’s balance sheet up until the conversion event. After conversion, they become equity in the company. As debt instruments, convertible notes also have a maturity date and can earn interest (two key differences with SAFEs, as outlined further down).

VCs use convertible notes for many of the same reasons they use SAFEs. Both forms of financing allow investors and founders to put off the question of valuation—often a point of disagreement between founders and investors—until a later date, so that companies can get funded sooner.

How Does a Convertible Note Work?

The mechanics of a convertible note depend on whether or not the company experiences a conversion event. In the absence of a conversion event, the convertible note functions like a traditional debt instrument, with an interest rate and a maturity date.

If the company does experience a conversion event, the total amount converting into equity will include the original principal amount on the note and any interest accrued to date. The price at which the convertible note will convert to equity will be determined by one of two things:

• Valuation cap. This is the maximum valuation at which a convertible note will convert. If the valuation cap is $5M and the priced equity round has a post-money valuation of $10M, the noteholders effectively invest as if they’re coming in at the lower valuation of $5M. The lower the convertible note valuation cap, the better the terms for the investors.
• Discount rate. Instead of a specific valuation cap, a discount rate gives noteholders a discount to the valuation at the priced equity round when they convert. A convertible note discount rate of 30% and a priced equity round with a post-money valuation of $10M, for example, would allow noteholders to effectively invest at a $7M valuation.

Some convertible notes will specify both a valuation cap and a discount rate. In this case, the note will typically convert at the lower of the two options—a favorable outcome for investors.

Keep in mind that, unlike SAFEs, not all priced equity rounds necessarily trigger a conversion. Convertible notes can have additional parameters around what qualifies as a priced equity round that triggers conversion, such as a specified minimum amount raised in the priced round.

For instance, if the convertible note term sheet stipulates that conversion will only happen if $2M or more is raised, but only $1M is raised, the convertible note would not yet convert to equity.

In the case of a liquidation event such as an acquisition, convertible noteholders usually have two options, depending on the negotiated terms.

• Option 1: Receive anywhere from 1x to 3x the original amount paid for the convertible note. This is known as a liquidation preference. For example, a 2x liquidation preference means the investor receives twice the note amount upon a liquidation event. So, if the investor invested in a $1M convertible note and the company was then sold, the investor would be entitled to receive $2M back.
• Option 2: Convert the note into common stock at a price determined by the valuation cap. Then, sell those shares to the acquirer as a part of the acquisition and share in the proceeds alongside all other stockholders.

Convertible Note Example

Assume you’re a founder who has just raised $1M via convertible notes. These notes come with a valuation cap of $5M, a maturity date 2 years from now, and an interest rate of 5%.

One year in, you manage to raise a $2M Series A, with a pre-money valuation of $8M and a post-money valuation of $10M. How much equity do these noteholders get?

Post-Series A, both the convertible noteholders and Series A investors would each have 20% of the company. However, the convertible noteholders only had to invest $1M for that 20%, while the Series A investors had to invest $2M for the same 20%.

Here’s a simple formula you can use to gauge how much equity a convertible note would give you upon conversion:

Further, the $50k in unpaid interest (5% on $1M over 1 year) accrued by the notes would also go towards the conversion.

SAFEs vs. Convertible Notes

SAFEs and convertible notes carry many of the same benefits for founders and investors; but there are also key differences that founders and investors should understand.

To learn more, read our guide to SAFEs.

Can a Convertible Note Be Paid Back?

Because convertible notes have maturity dates, a question that often arises is: What happens if a conversion event doesn’t happen before the maturity date? Does the convertible note have to be paid back?

In theory, because they are debt, convertible notes must be paid back. But in practice, this is rarely the case. If a startup fails to raise a priced equity round before the maturity date, it’s highly unlikely it will have the funds needed to repay the note principal.

In such a case, the convertible noteholders have several options:

• Force a repayment. Technically speaking, the noteholders could demand repayment of the note. Because the company is unlikely to be able to do so, this could force the company into bankruptcy. This option is rarely taken, as this would not serve the interest of the noteholders or the founders.
• Extend the maturity date. More commonly, the noteholders will agree to extend the maturity date of the convertible note to give the founders more runway to raise a priced equity round. This extension might also involve a renegotiation of other terms, such as lowering the valuation cap or increasing the discount rate.
• Convert the note to equity at a renegotiated valuation cap. The noteholders can also elect to convert the note to equity right away and become direct shareholders. However, considering the circumstances, it’s likely that they would renegotiate the conversion price in their favor—giving them a higher shareholding percentage.

Why Do Startups Use Convertible Notes?

Founders like convertible notes for several reasons:

• Lower costs. Convertible notes usually incur much lower legal and administrative costs compared to priced equity rounds. However, they tend to be a bit more expensive than SAFEs as there are additional terms (like the maturity date and interest rate) to consider.
• Faster and simpler negotiations. With fewer terms to negotiate compared to priced equity rounds, negotiations are simpler and can be concluded faster. Again, though, SAFEs hold the advantage—they’re often even faster.
• Quicker access to financing. Speed and simplicity means startup founders can receive funding on a shorter timeline.
• Retaining control of the company. As debtholders, convertible noteholders typically won’t get a say in the direction of the company until their notes convert to equity.

Meanwhile, venture investors use convertible notes for their own reasons:

• Negotiating favorable conversion terms. Since they’re coming in at an earlier stage, investors can often negotiate for favorable conversion terms, such as a lower valuation cap or higher discount.
• Interest payments. Investors may receive interest payments which can convert into equity.
• Saving time and money. Reduced costs and complexity means investors can close more deals, faster.
• Superior liquidation preferences as debtholders. Unlike SAFEs, convertible noteholders typically have more than a 1x liquidation preference—in addition to getting paid before both shareholders and SAFE holders.

Key Considerations When Using Convertible Notes

Investors should be aware that convertible note financing at later stages can be taken as a negative signal, implying the company was unable to raise a traditional priced funding round at a stage when valuations are common.

There are some key considerations for founders, too:

• How much equity are you giving up? If there’s a big gap between the convertible note valuation cap and the eventual valuation in the priced equity round, the founder (and other future investors) could end up being more diluted than they initially expected.
• Will interest payments strain your cash? If interest payments end up being paid out, servicing those payments could strain cash flows, consuming funds that may be better used to grow the company.
• Will an overly complicated cap table put off future investors? Having too many convertible notes—particularly if they all have different terms—could result in a messy cap table. This could be a deterrent for future investors.

Convertible Notes and Taxes

Convertible notes can be classified as either debt or equity for U.S. tax reporting purposes, depending on the facts and circumstances. In practice, most convertible notes are treated as debt, but it’s always advisable for companies to consult a U.S. tax advisor when classifying these instruments for reporting purposes.

Understanding Convertible Notes

Debt financing is and will continue to be a common investment approach for early-stage companies. Both founders and investors should thus have a firm grasp of convertible notes and their implications.

To learn more about how the various pieces we discussed would fit together in a single document, refer to Fenwick’s convertible note template.