For founders looking to attract quick bridge financing before or in between venture capital rounds to “keep the lights on,” convertible loan notes often become the weapon of choice. Sitting at the crossroads of debt and equity financing, convertible notes can be a necessary option for early-stage startups that:
- Struggle to raise a full funding round
- Haven’t yet arrived at their valuation
- Don’t want to dilute their ownership
- Want to retain complete control early on
- Want to bypass traditional high-interest loans
But to fully reap those benefits and avoid getting into a debt you can’t pay, you must understand the nuances of this financing tool.
By the end of this article, you will:
- Get an answer to “what is a convertible note?” question
- See all the conversion scenarios on a hypothetical example
- Weigh their pros and cons
- Learn tips on negotiating a better deal
What is a convertible note?
A convertible note (also goes by convertible loan, convertible bond, or convertible promissory note) is a hybrid form of debt and investment that, under the circumstances set by the creditor (investor) and the borrower (company), has a perspective to convert into equity in the company it was given to.
The circumstances for the conversion typically include the company 1. raising a full venture capital funding round or 2. reaching a certain valuation cap. That’s when the creditors can exchange their convertible notes for a stake in the company at a discount.
If the circumstances for the conversion never take place, unless the company goes bankrupt, it typically repays the convertible note with interest over a specified period. If the company goes under, the funders are treated as unsecured creditors and may or may not get some of their investment back, depending on the situation.
Like in any typical transaction, two parties are involved: the investor that commits the capital and the company that issues a convertible note in exchange for the capital. Before this exchange, both parties must agree on the terms to fit the unique circumstances.
Convertible notes share traits of both debt and equity. This versatility allows for higher customization and accessibility than traditional debt or equity financing mechanisms, making it a quicker and easier alternative for founders and investors.
Components of a convertible note agreement
The way a convertible loan note works—how it converts into equity, what happens if it doesn’t, etc.— depends on the convertible note terms the investor and the founder agreed upon.
Here are the 5 clauses that form the basis for a convertible note agreement and determine what happens and when:
Like any loan, convertible notes appreciate over time through interest at a rate both parties agreed upon. Although there are some rare deals with 1% or 0% interest rates, commonly, the rate averages 4-8%.
The interest then gets added to the principal amount at the maturity date, when investors can either use it to buy shares or ask for repayment in cash, depending on the other agreement terms.
That’s the date when the loan is due to be repaid with interest if the note hasn’t been converted into equity. This data is defined by your stage, market, economic climate, and the amount you’re asking for, but normally ranges from one to three years.
Often, however, investors agree to postpone the maturity date to let the startup hit the planned milestones and reach the conversion point.
For your debt note to convert into equity for investors, one of two things typically must happen: you either raise a further funding round and land at a valuation, or someone acquires your company.
A convertible note valuation cap is the highest valuation (normally, pre-money) at which investors’ notes will convert into equity during the next funding round. This cap is typically lower than the actual company valuation, allowing the noteholders to gain a higher percentage of the startup.
For example, if your company is valued at $10 million but the valuation cap is $2 million, a $200,000 investment would convert into a 10% stake instead of 2%.
But the opposite is also possible: if the convertible note valuation cap is higher than the actual startup value, investors will receive the short end of the stick, leaving you with more equity. That’s when they might opt to convert their shares by using a discount.
If the valuation cap at the moment of conversion doesn’t satisfy investors, they can opt for buying shares at a discount you agree upon.
Basically, instead of paying the total price for your shares like the new investors—the price you base on your pre-money valuation and the number of outstanding shares—the noteholders get them with a discount.
The earlier the stage, the higher the discount the noteholders receive: Pre-Seed to Series A startups normally offer 20%-30%, while Series B and beyond stay within a 10% to 20% discount.
For example, if you agree upon a 20% discount, investors will use their investment amount + interest to buy your shares at 80% of their actual price at the moment of conversion.
Convertible notes vs. Equity: What’s the difference?
To better understand what a convertible note is, let’s see how it differs from qualified financing, aka venture capital round.
How a convertible note works: Conversion process example
Let’s use a hypothetical scenario: an early-stage company issues convertible notes, then successfully raises a qualified funding round, and these notes convert into shares.
Before the convertible note agreement is signed, the company is owned by two people, each owning 1,5 million shares (3 million in total).
- Investment amount: $750,000
- Interest rate: 6%
- Discount rate: 25%
- Pre-money valuation cap: $8 million
- Maturity date: 2 years
The conversion event
A year later, the company raises their $2 million for investment, at a pre-money valuation of $12 million. The new investor share price is then calculated by dividing the pre-money valuation by the outstanding shares (held by the founders). So, $12M ÷ 3M shares = $4 per share.
This means new investors get $2M ÷ $4 = 500,000 shares.
With the new valuation and share price set, the conversion can happen based on either the valuation cap or the discount rate, depending on whichever offers noteholders a better deal:
Valuation cap scenario: new investor price per share * (Valuation cap ÷ Pre-money valuation) = $4 * ($8M ÷ $12M) = $2.67 per share.
Discount rate scenario: New investor share price * (1 – discount rate) = $4 * (1 – 0.25) = $3 per share.
The most favorable scenario for our investors is to go with the valuation cap at $2.67 per share.
By this time, the interest has accumulated on the investment: $750,000 * 6% = $45,000. The total amount for conversion: $750,000 (principal) + $45,000 (interest) = $795,000.
Convertible note to equity: $795,000 ÷ $2.67 per share = approximately 297,753 shares goes to the noteholder.
After the dust settles, the cap table transforms:
- Note converters wield 297,753 shares, leaving them with a 12.5% stake
- New investors get 500,000 shares, controlling 9.92% of the company
- Founders hold their original 3 million shares, owning a %77,58 stake
The conversion leaves the founders’ share diluted by %22,42.
Pros and cons of convertible notes for startups
- Delayed valuation: Convertible loan notes allow you to postpone your startup’s valuation until it’s more developed and easier to assess.
- Quick results: Convertible notes are a great bridge-capital or intra-round financing option. They attract investors easier than equity rounds and cut through the red tape and lengthy negotiations associated with equity deals, getting funds into your hands faster.
- Ownership, retained: Early on, keeping a firm grip on your company’s reins can be crucial. Convertible notes are debt, so they don’t dilute your ownership until they convert—a big plus for maintaining control.
- Milestone pusher: Convertible debt notes come with an inbuilt timer, ticking down to your next big funding event. For many founders, this is a strong motivator to hit growth milestones within a set timeframe.
- Future dilution risk: When notes convert to equity, your slice of the pie gets smaller. It’s essential to negotiate your valuation caps or discounts wisely, or you might find your ownership percentage shrinking more than you’d like.
- Debt obligation: Until they convert, these notes are a liability on your books. If the winds don’t blow in your favor, this could become a financial anchor weighing down your venture and discouraging other investors from joining it.
- Future financing complications: Convertible notes can complicate future financing rounds. Future investors will scrutinize the terms of the notes, and the dilution effect of their conversion can impact the attractiveness of the company for additional funding.
- Risk of default: If you fail to raise additional funds or achieve a successful exit before the maturity date, you can face the risk of defaulting on the debt—a cliffhanger no founder wants.
So, what’s the verdict?
Hopefully, we got convertible notes explained as thoroughly as possible. Ultimately, the success of convertible notes as a form of bridge financing depends on your ability to:
1. Negotiate favorable terms
2. Reach set milestones
3. Secure subsequent rounds of VC funding
Do your homework by studying the market and similar cases; if unsure, seek professional advice. Employ strategic foresight and prepare for all possible scenarios after you raise the money, including the worst-case one. Don’t be afraid to negotiate and stand your ground, but base your terms on the market reality.
But most importantly, after you sign the agreement, make sure that you know how to hit growth milestones and how to attract more funding.
If you want to know how to do this, check out our content hub. There, we share our advice stemming from years of experience helping startups raise funding.
What is a convertible promissory note?
A convertible promissory note (or convertible debt note/loan) is a form of bridge financing initially given to a company as a debt with a perspective to convert into equity in the future. How and when this conversion would take place, as well as what happens if it doesn’t, is decided upon by the investor/creditor and the founder in a convertible note agreement.
Does the loan in a convertible loan note need to be repaid?
Yes, it does, unless the company declares bankruptcy. In that case, investors are treated as unsecured creditors with a lack of priority in repayment, which may leave them with little to no repayment.
If the company doesn’t go under, the convertible loan note can be repaid in two ways: in cash (principal amount + interest) or by converting into equity in a company.
What happens to a convertible note if startup fails?
If a startup fails, convertible note holders, as unsecured creditors, face a significant risk of loss. They are in a better position than equity investors but still may recover little to nothing from their investment, depending on the company’s financial situation at the time of its failure.
How does a convertible note work?
Investors provide a startup with a loan in exchange for a convertible note. This note contains terms like interest rate, maturity date, valuation cap, and discount rate. The conversion from debt to equity is usually triggered by the startup’s next significant financing round or acquisition. The investment amount and the accrued interest are then converted into equity based on the terms. If the event doesn’t occur, the company must pay the debt with interest.