Unlike a traditional priced equity round, a convertible note is a type of debt that converts into equity (typically during a future financing round). Essentially, it’s a loan made to a startup by an investor, with the expectation that the loan will convert into shares of the company’s stock at a later date. This instrument combines elements of debt and equity, offering flexibility for both parties.

Key Features of Convertible Notes

1. Principal and Interest
   The investor provides a principal amount as a loan to the startup. This loan accrues interest over time, which is also converted into equity upon maturity or during a qualifying financing event.
2. Conversion to Equity
   Convertible notes are designed to convert into equity on some future trigger. The most common future trigger is a financing round, which usually involves conversion at a discounted rate compared to new investors. Other conversion triggers could be a sale of the company, the election of the company or the investor on pre-determined terms, or some other trigger such as the release of a game or achievement of some sales milestone.
3. Valuation Cap
   A valuation cap establishes a maximum company valuation at which the note will convert into equity. This feature protects early investors by ensuring they receive a favorable conversion rate if the company’s valuation skyrockets. At the same time, it disadvantages founders by requiring them to surrender a larger piece of company equity to early investors (compared to a discount) if the company’s valuation rises substantially before a subsequent financing round.
4. Discount Rate
   A discount rate provides a reduced price per share for note holders compared to new investors in the subsequent financing round. This rewards early investors for taking on higher risk.
5. Maturity Date
   Convertible notes have a maturity date, at which point the loan must either be repaid with interest or converted into equity. If the startup hasn’t raised a qualifying financing round by this date, negotiations may be required to determine the next steps.

Benefits of Convertible Notes

1. Speed and Simplicity
   Convertible notes are generally quicker and simpler to negotiate compared to equity financing rounds. This efficiency can be crucial for startups needing fast access to capital. While more complicated than SAFEs, they also offer more flexibility on terms.
2. Flexibility
   The hybrid nature of convertible notes provides flexibility for both founders and investors. Startups can delay setting a valuation until a later stage, while investors gain potential equity in a growing company.
3. Investor Protection
   Features like the valuation cap and discount rate protect investors by ensuring they receive a fair conversion rate relative to future financing rounds. This can make convertible notes an attractive option for early-stage investment.
4. Alignment of Interests
   Convertible notes align the interests of founders and investors by focusing on the company’s long-term growth. Both parties benefit from the startup’s success, as the loan converts into equity at a favorable rate during a successful financing round.
5. Avoids a “Priced Round”
   For various reasons, founders and company executives may want to avoid pricing the company’s equity too early. A convertible note allows for money to come in from investors while kicking the can down the road on pricing the shares, specifically.

Considerations and Risks

While convertible notes offer many advantages, they also come with certain risks and considerations:

• Debt Obligation: Until conversion, convertible notes are a form of debt, and the startup is obligated to repay the loan if it doesn’t convert to equity.
• Dilution: The conversion of convertible notes into equity can lead to significant dilution for existing shareholders.
• Negotiation Complexities: Convertible notes can have a lot of moving parts (such as those listed above). At maturity, if no qualifying financing event has occurred, renegotiating terms can be complex and time-consuming.

Conclusion

Convertible notes are a valuable tool for early-stage fundraising, offering speed, simplicity, and flexibility. By understanding their structure and benefits, startups and investors can make informed decisions that support the growth and success of the business.