May 26, 2022
Venture Capital

Everything You Need to Know About Convertible Notes

Bram Berkowitz

f you’re a young, promising startup looking to raise capital, a traditional bank loan is likely out of the question. Your company is too risky. This means you’ll need to go and find capital in the private markets. But because you’re early on in your life cycle, it might be a bit too early to raise serious venture capital.

Enter convertible notes.

A convertible note enables startups typically at the pre-seed or seed stage to raise short-term debt from investors. But instead of paying off that debt every month with interest like a traditional bank loan, startups issue a convertible note that investors can exchange for equity in the not-too-distant future (likely over the next 18 to 24 months). Because raising capital through these vehicles is so different than traditional financing, this blog outlines everything you need to know about convertible notes.

Why would a startup decide to use a convertible note?

Convertible notes allow startups to raise money quickly – sometimes in mere days – whereas a bank loan or other kinds of financing can involve lots of paperwork and takes much more time. 

Convertible notes may also cost the startup less in legal fees. According to Crunchbase, legal fees can be as small as $1,500 to $2,000 for a convertible note. But if you were to issue some kind of common or preferred stock, it could cost anywhere from $10,000 to $30,000. 

As a new startup, you likely don’t want to be paying this kind of money in legal fees just yet. The other great thing is that, unlike traditional debt, startups don’t have to pay back principal and interest each month, which allows startups to focus all of their energy on running the business. 

Why would an investor decide to use a convertible note?

For investors, there can be a lot of upside when they decide to convert the note to equity if the startup takes off. Investors usually push to have their note into preferred stock for taking a big risk early on, which receives preferential treatment over common stock. 

The terms of preferred stock vary but it’s likely that preferred investors get their money back before common investors in a liquidation event if the company goes belly up or sells for a less-than-enthusiastic price. Investors with preferred stock can also get special perks like a board seat, which gives them input on the strategic direction of the company.

Disadvantages of a convertible note

Like with anything, it’s not all sunshine and rainbows with convertible notes. There are several potential disadvantages for both the investor and startup, but here, we’ll focus on the big ones. The startup could end up giving away far more equity than they might have ever imagined if the company takes off and gets a huge valuation, making the amount of debt they initially received from the note look paltry compared to what the investor’s equity ends up being worth. On the other hand, most startups fail and don’t ever secure a future round of financing, meaning it’s unlikely the investor will see any upside or even get their money back.

What are the different components of a convertible note?

While raising convertible debt is typically easier than other financing rounds a startup might conduct over the course of its life, that doesn’t mean there aren’t certain terms and complexities they need to agree on with the prospective investor. 

There are four main components of a convertible note:

●  Discount rate - This is the discount investors receive on shares in future financing rounds. Remember, the investor is taking a big risk on an early-stage startup and therefore should be fairly rewarded. So, if the startup reaches a series A round, which is typically when the note would actually convert to equity, if new investors receive common shares valued at $10 each and the convertible note investor gets a 15% discount, that means they would receive shares valued at $8.50.

●  Interest rate - Although we said earlier there are no traditional interest payments like on a bank loan, there actually still is an interest component to the convertible note, which at its core is still a loan. No, the startup will not have to pay interest in cash, but there will be an agreed-upon interest rate, which the investor will receive in the form of additional shares when the note converts. There’s no such thing as free money.

●  Valuation Cap - A valuation cap is another way for the startup to sweeten the deal for the investor for taking on the risk. As its name suggests, this mechanism caps the valuation at which the investor’s shares convert. This is great for the investor because it enables them to convert their shares at a lower valuation, which gives the investor a higher percentage of the company. 

For example, if there is a convertible note for $200,000 with a valuation cap of $10 million, and the company is valued at $20 million in their series A round, the investor’s stake in the company is 2% ($200k/$10M). New investors putting in $200,000 during the round would receive a 1% stake ($200k/$20M). The lower the valuation cap the better for the investor.

●  Maturity Date - This clearly sets forth when the note is due. As we mentioned, a typical maturity date is 18 to 24 months out. This sounds like a simple concept but isn’t. In theory, if the set time for the note passes and it still hasn’t been converted to equity, the investor can call the note and request the startup pay back the full principal plus interest. But this rarely happens in the startup world because the investor would essentially be hurting themselves in the process. 

Even if the startup has no path to the next equity round, they’ve likely spent the investor’s money at this point and don’t have much left to pay back. Putting the startup further in the hole makes it unlikely they will ever reach the next round, which is where all of the investor’s upside is. This is of course the big risk for investors – that their note will never convert (and many don’t). 

Furthermore, if the investor calls the note the startup founder is not going to be happy and will likely spread the word to their founder friends, which then gives the investor a bad reputation. Typically, the investor will extend the maturity date of the note and give the startup more time to reach the next round of financing.

Convertible note example

Let’s wrap up with an example. Let’s say Lucy and her sports-ticketing company, BungeeTickets, issues a convertible note to an angel investor named Carlos for $1 million. Lucy and Carlos agree the note will mature in 24 months or convert to equity in the event of a Series A round. 

The note has a valuation cap of $10 million, a discount rate of 20%, and an interest rate of 10%. Lucy works incredibly hard, grows the company significantly, and before the 24-month time period is up, Lucy is ready to raise a Series A funding round to really double down on growth. After all, she’s going to need money if she wants to be in every sports stadium in America. Investors like what Lucy is pitching and she raises a series A round at a $25 million valuation and prices shares at $20. 

Carlos is loving it! In this situation, his shares will convert at whatever is the more favorable valuation is for him. His 10% interest on his $1 million note gives the note a full value of $1.1 million. With a 20% discount rate, Carlos could get shares at $16, which gives him 68,750 of preferred shares ($1.1M/$16). 

To calculate how many shares Carlos would get with a valuation cap of $10 million, he would divide $10 million by $25 million. That would give Carlos shares at just $4 and therefore his $1.1 million stake would be worth 275,000 preferred shares, making the valuation cap the method by which Carlos would convert his note at.

At the end of the day, finding the right funding is one of the most important parts of business progression and growth, especially for startups. If you’re an early-stage startup with rapid growth potential, you might be considering your options for venture capital. Although not right for every startup, you do have the option to explore venture capital funding, including convertible notes, if you think they’ll be the best choice for your business.

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