Financing a startup or emerging company requires diligence and complex agreements to protect your company’s best interests. A convertible note investment is a form of debt financing, used by early-stage companies that are not yet ready for a priced-round financing.
Is convertible debt a better option for your business than a SAFE or other investment vehicle? While convertible notes were more common several years ago, over the past 5 years SAFEs have become the more prevalent vehicle used in early-stage and seed-stage financings.
What is a Convertible Note Investment?
A convertible note investment is a form of debt financing that is common for early-stage startups. While the goal of debt financing for the lender is typically repayment of principal plus interest, with convertible notes the goal is for the loan to convert into equity when the startup does a preferred stock financing. Interest is accrued, rather than paid out over a set schedule, and when the note converts, the accrued interest is also converted into equity. By converting the principal and interest into equity, the lender/investor can benefit from the potential for the equity to increase in value.
How Does a Convertible Note Investment Work?
A convertible note investment has conventional loan terms and a “conversion event.” The note will have an interest rate and a maturity date. To make the investment more attractive to the investor, the note converts at a discount. The discount could be based on a straight discount (usually 20%), or on a valuation cap.
For example, the investor may agree to lend you $100,000 at a 10% interest rate with a two-year maturity rate. If the startup does a Series A financing at the end of the first year, the principal and accrued interest – $110,000 total – will convert into equity, but at a discount to the price being paid by the new investors. For example, if the new investors are paying $1 per share, and the note converts at a 20% discount, the note will convert at $0.80 per share. This means that the $110,000 in principal and interest will convert into 137,500 shares of preferred stock, rather than 110,000 shares.
Convertible Note Terms for Founders to Understand
Four terms that all investors and startups should know are:
- Discount rate: A discount on the share price of the stock, often 20% for early investors.
- Interest rate: Convertible notes carry interest, which is converted into equity on top of the principal investment. The typical interest rate will be between 5% and 10%.
- Maturity date: The date when the note is due, and the investor requires repayment. This will usually be 2-3 years out.
- Valuation cap: If there is a valuation cap, then the note will convert as if the valuation in the later equity financing is that number, rather than the actual valuation being used in the equity financing. Of course, this only works for the investor if the valuation cap is lower than the pre-money valuation.
When Does Convertible Debt Turn Into Equity?
A convertible note will convert at the startup’s next funding round where the startup issues preferred stock. It is also common to include provisions for the convertible note to convert upon a sale of the company.
What Happens if a Note Doesn’t Convert?
Your startup may not reach a conversion event before the note hits maturity. If this happens, the best path forward is to negotiate with the investor to extend the maturity date. Keep in mind that investors may demand that the discount be increased, in exchange for extending the maturity date. This problem is why startups generally prefer using SAFEs, which have no maturity date.
What Are the Benefits of a Convertible Note Investment?
Convertible debt has advantages for founders and investors. One of the primary advantages for startups is that valuation is not required, making convertible notes good vehicles for early-stage companies.
Founders Maintain Control
Investors who hold convertible notes do not have any voting rights until their notes are converted into equity.
Company leaders will still remain in control of the startup’s direction and decisions.
Convertible notes are known as “bridge financing” for this very reason. They help “bridge the gap” between seed funding and a Series A round, which establishes formal governance and equity ownership.
Lower Legal and Administrative Costs
Priced equity rounds add a layer of complexity to the funding process. Documentation is more complex, and the startup has to be valued.
Convertible notes, on the other hand, are relatively simple and straightforward as far as documentation is concerned. For this reason, legal and administrative costs tend to be lower, and the timeline to close an investment is shorter.
The maturity date and interest rate, however, make this option more expensive than a SAFE.
An Attractive Option for Investors
For investors, convertible notes are an attractive option for several reasons.
- More favorable terms, such as a higher discount or lower valuation cap, can be negotiated because this funding is coming at an early stage.
- Lower costs and a simple process means that closings can happen faster.
- Investors may receive interest payments that can be converted into equity.
These are all attractive features for investors, which means that startups can obtain the funding they need much more easily compared to other funding options.
Key Considerations for Convertible Notes
The advantages of convertible notes are clear, but there are a few considerations that should be kept in mind.
- Equity dilution. Founders should consider how much equity they will be giving up. A large gap between the valuation cap and valuation in the priced equity round could leave founders more diluted than expected.
- Interest payments. Because convertible notes accrue interest, when the notes convert to equity, so does the interest, thereby causing more dilution.
- Messy cap tables. When startups have too many convertible notes and with varying terms, the cap table can become overly complicated and be a deterrent for future investors.
- Convertible notes are debt, and will be treated as such on the company’s balance sheet. If the startup has raised extensive money through convertible notes, the startup could be deemed insolvent.
These are just a few key considerations of convertible notes. Although they have many benefits, it is crucial to understand the implications of this form of funding for your individual startup.
Having the advice of an experienced professional is key.
SAFE vs. Convertible Investment: Which Is Right for Me?
SAFEs and convertible note investment share many of the same advantages for founders and investors. However, there are key differences – most importantly, the maturity date and interest accrual. Convertible notes accrue interest and have a maturity date, while SAFEs do not.
Every startup is unique, with its own challenges and considerations.
Consulting with a professional experienced with negotiating and navigating SAFEs and convertible notes is key.
Kinetic Law has many years of experience advising startups on funding options.
Paul Spitz, founder of our firm, is a former CEO who understands the unique needs and pressures entrepreneurs face.
Contact us today to schedule a consultation and learn more about our services. Through our office in Cincinnati, we offer virtual services to clients throughout Ohio and California, including the San Francisco Bay Area, Silicon Valley, San Diego and Los Angeles.