How Do Convertible Notes Work?

author avatar by Greg Miaskiewicz • 9 min

Suggested Reading: How Do SAFEs Work?

Early stage startups often use a financial vehicle called a convertible note (somewhat similar to convertible equity, but not the same) when fundraising in the pre-revenue stage. In plain english, convertible notes allow investors to provide funds to a company and receive promissory notes which will convert to equity, based on the valuation at a future date.

These notes could also be structured to trigger when certain conditions are met in the future, and almost always mature at the next qualifying fundraising 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.

Convertible Notes Are Debt (Not Equity)

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 really 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 of early stage investors by setting a maximum valuation at which their invested capital will convert into equity in the next priced financing round.

In typical arrangements, the balance of the convertible note will convert into preferred shares at the level of the next round, along with the interest and discount amount. In some arrangements, the interest and discount amount will convert as common shares.

It’s important to note that if the valuation cap is surpassed, the higher of the discount rate or valuation multiplier will be in effect—not both. Let me give you an example of how this could look:

Superglide Ventures has invested $2 million in your company at the seed round at a valuation cap of $10 million with an interest rate of .05% and a discount rate of 25%. Your next round of fundraising, you receive a valuation of $20 million from your Series A investors, double your valuation cap.

At a 25% discount rate, they’ll be eligible to receive $250K more in shares for their note. However, since their valuation cap is half the new valuation, this makes them eligible to receive twice as much equity as their initial investment, for a total of $4 million in preferred shares at the Series A price.

They will take the greater of these numbers, $4 million, and add on their interest as equity—if we assume the note has been held for 1 year, they will receive $160,000 worth of additional shares. This means they will receive a total of $4,160,000 in Series A Preferred shares.

Of this total, $2,000,000 in shares (the principal) are converted into Series A Preferred shares, and the additional $2,160,000 (the interest and discount) convert as well. To quickly translate the convertible notes held into a share amount, you can simply divide the valuation cap by the next series valuation.

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.

TL;DR:

  • 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.

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author avatar

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.

DISCLOSURE: This article is intended for informational purposes only. It is not intended as nor should be taken as legal advice. If you need legal advice, you should consult an attorney in your geographic area. Capbase's Terms of Service apply to this and all articles posted on this website.