What is a Convertible Note?

It is time to fundraise and you are trying to decide what you need to give your investors in exchange for their investment. More likely than not, you have heard of convertible notes and have wondered exactly what they are and how they work. A popular option for startups and more advanced companies alike, convertible notes are an excellent way to keep your current equity table simple, all the while sweetening the deal for your investors by offering a more-than-enticing interest rate.

A convertible note is a promise to pay back an investor who “loans” your company cash now. Like any loan, a convertible note has an interest rate (typically between six and 10 percent in today’s market), a maturity date (when it has to be paid back), and some default provisions that require immediate payment (the “Whoops! You messed up and you need to pay us back now provisions!”). Convertible notes do, however, have a few special features that make them an attractive investment prospect for early-stage investors:

CONVERSION ON NEXT EQUITY ROUND

In the future, they convert into company equity (stock). The key feature of a convertible note is that it should, assuming everything involving the company continues relatively on course, turn into company stock at a later date. Most convertible notes automatically convert into equity in the next round of equity financing (i.e., the next time the company sells stock). Usually, that next round will have a minimum amount of equity to be sold (this is the threshold amount—so if less stock is sold than the threshold amount, the note will not convert). This is called a qualified financing. The note will typically convert into the same type and class of equity (common, seed, or preferred) as sold in that next round and with the same rights as those of new investors. Plus, the noteholders will not have to do anything to make the notes convert—it will happen automatically.

DISCOUNT

When they convert, the holders will receive a discount on the conversion price for the new equity. Typically, when the notes convert into new equity upon a qualified financing, the conversion price (the price per share “paid” by using the outstanding principal and interest on the convertible note) will be at a discount to the price per share paid by new investors. Typical discounts are between 15 and 25 percent (with 20 percent being most common) and most companies now find they are also required to include in their notes a conversion cap. (See our blog entitled “How Do Conversion Discounts Work?—And What’s a Conversion Cap?” for further information.)

CONVERSION ON SALE OF COMPANY

There may be other circumstances in which the notes may convert into equity, either automatically or at the option of the note holder. Many convertible notes include provisions that require conversion of the notes into equity upon the sale of the company or a sale of all, or substantially all, of its assets. This is often called a deemed liquidation event and is included so that investors will receive the benefit of being a stockholder of the company if there is a positive exit. Typically, the notes will convert into common equity upon this event and the price per share is negotiated ahead of time by the company and the note holder (if there is a conversion cap, the price per share is determined by using the conversion price calculated in accordance with the conversion cap).

OPTIONAL CONVERSIONS

There are also some notes that include optional conversion at the discretion of the note holder upon (a) maturity of the note or (b) at any time. Optional conversion is not the market norm, but is also not atypical.

Finally, some notes include conversion at the option of the company or pre-payment at the company’s option. Both of these features are fairly rare and are typically only negotiated successfully by companies with a more successful track record and a “hot” round (meaning there are many investors vying for the opportunity to invest).