What are convertible notes and how they work?
Suggested Reading: How Do SAFEs Work?
Early stage startups often use a financial vehicle called a convertible note when fundraising in the pre-revenue stage. Convertible notes allow investors to provide funds to a company and receive promissory notes which convert to equity based on the valuation at a future date.
These notes can also be structured to trigger when certain conditions are met in the future, and almost always mature at the next equity financing round. Note that as a term, “qualifying” is negotiable.
Because valuing an early-stage company is extremely difficult, convertible notes do not set a price for the company. When they are used for a fundraising round, that round is typically referred to as an un-priced round.
The two most commonly used types of convertible equities are a convertible note and a SAFE (Standard Agreement for Future Equity). Convertible notes are older instruments and essentially function the same way that loans do—except they are paid back in equity.
How convertible notes work
As a classic debt instrument, a convertible note is structured with a relatively short list of terms and typically matures after 18-24 months, upon which time it must be paid back with interest, generally between 2% and 8%. Since convertible notes were not really designed for seed series funding, they tend to work a slightly different way in the startup world.
Functionally, the maturity date of the convertible note serves as a rough deadline for your next round, at which point the convertible note will be converted into preferred stock (equity) at a particular discount rate relative to the new valuation. The interest rate from a convertible note typically accrues until the note converts into equity at the next round.
Arguably the most important term of the convertible note is the valuation cap, which rewards the risk taken by early stage investors by setting a maximum valuation at which their invested capital will convert into equity in the next priced financing round. That limits the share price at time of conversion, while ensuring the convertible note holder receives a higher number of shares than they would without the cap.
If the valuation cap is surpassed, the higher of the discount rate or valuation multiplier will be in effect—not both. Here’s an example:
Liger Capital Management invests $250,000 in your company, in the form of a convertible note. The note has a $3,000,000 valuation cap, and a 20% discount.
Then your Series A rolls around. Your company’s pre-money valuation is $16,000,000. When their note converts, how much of your company will Liger Capital Management receive?
The valuation at which the note converts can be based on either the valuation cap or the discount—whichever results in the biggest ownership share for the noteholder.
First, let’s calculate the discount. If your pre-money valuation is $16,000,000, a discount of 20% will result in a valuation of $12,800,000.
The convertible note’s value of $250,000 is 1.95% of 12,800,000.
Next, let’s calculate the valuation cap. In this case, the value is capped at $3,000,000. Since $250,000 is 8.3% of $3,000,000—and that’s considerably more than $1.95%—the note converts at this valuation.
(Keep in mind that this is Liger’s pre-money ownership in your company. Stock dilution will lower that number, depending on how much other parties have invested in your company, and how much additional stock you have authorized as a result.)
Startup investors are generally not looking for marginal returns from interest. They want equity that appreciates in value rapidly, so they don't generally pay much attention to the maturity date as long as a priced round is likely to close in the near future.
It is notable that it is possible to roll over convertible notes to the next round in some cases, though this is seldom done in practice. Capbase has created template convertible note agreements and tools to issue standard convertible notes to make getting funding for a startup as simple as possible.
A Word About The Valuation Cap
While the valuation cap is not a “valuation” in the sense of a 409a valuation, it is one of your overall valuation methods it does set the tone for future rounds—make sure you’re considerate when setting yours. There are some disadvantages that SAFEs and convertible notes share, and some that are unique to each.
It’s easy for both to cause future dilution if their valuation cap is low or if many investors are added without a thorough consultation of the cap table regarding their future impact. Capbase helps you visualize how convertible equities convert into equity at the next priced round, so it’s easy to understand how much equity you are giving away in a round of convertible debt financing (or SAFE round).
Convertible Note Disadvantages
Outside of the disadvantages they share with SAFEs, convertible notes have their own peculiarities. Because of their structure, they may be re-negotiated, and also typically contain a preference clause that means they must be satisfied before other investments, save debt.
In the unlikely event of “preference overhang”, this can mean that a company selling at a valuation significantly below their valuation cap could be rendered illiquid.
Here’s how that looks: An investor has a $2 million convertible note at a valuation cap of $20 million, the company sells in a fire sale for $3 million with $1.5 million of debt to satisfy and must satisfy the convertible note leading to a negative overhang of half a million dollars. Scary—but unlikely.
- Early stage funding is typically done in unpriced rounds using either SAFEs or convertible notes.
- Convertible notes are debt instruments with maturity dates, interest, valuation cap and a discount rate.
- SAFEs are generally easier and friendlier for founders—some investors prefer SAFEs to convertible notes and vice versa,
- Capbase simplifies the process, allowing you to easily negotiate and execute convertible notes with your investors, and track their value over time.
Learn what the Most Favored Nation clause means in investing, how it is used in startup financing agreements, and why investors like it so much.
Written by Greg Miaskiewicz
Security expert, product designer & serial entrepreneur. Sold previous startup to Integral Ad Science in 2016, where he led a fraud R&D team leading up to a $850M+ purchase by Vista in 2018.
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