𝗔𝗥𝗘 𝗖𝗢𝗡𝗩𝗘𝗥𝗧𝗜𝗕𝗟𝗘 𝗡𝗢𝗧𝗘𝗦 𝗦𝗛𝗔𝗥𝗜𝗔𝗛 𝗖𝗢𝗠𝗣𝗟𝗜𝗔𝗡𝗧? - 𝗣𝗔𝗥𝗧 𝟭
A convertible note is a short-term debt that eventually converts into equity. Convertible notes operate as interest-bearing loans. The investor will either receive a balloon payment on the note at a specified date (maturity date), usually one year from date of the loan, or be allowed to convert the note into preferred shares during a future equity funding event. Typically, instead of receiving the principal sum back with the accrued interest, the investor gets shares of preferred stock as part of the start-up’s initial preferred stock financing.
To compensate for the risk taken, start-ups offer a valuation discount to investors. Let’s illustrate this by way of an example. Suppose an investor injects a $100,000 convertible note in a start-up with a 10% discount rate. Subsequently, the company gets a $1 million valuation, with 1 million shares having a per-share value of $1. In the absence of a discount, the $100,000 convertible note would convert to 100,000 shares. However, with the 10% discount rate, the note is converted into 111,111 shares because the share price is reduced to $0.9 at conversion.
Key Features of Convertible Notes:
1️⃣ Debt Instrument:
Convertible notes are initially issued as debt, meaning the startup promises to repay the investor the principal amount plus interest.
2️⃣ Conversion to Equity:
Instead of repaying the debt in cash, the note converts into equity (shares) in the company, usually at a later date when the startup raises a more substantial financing round.
3️⃣ Discount Rate:
To compensate for the early risk, investors are often given a discount on the price per share at which the note converts into equity. Common discounts range from 10% to 30%.
4️⃣ Valuation Cap:
A valuation cap sets the maximum company valuation at which the convertible note will convert into equity, protecting early investors from excessive dilution if the company’s valuation skyrockets.
5️⃣ Interest Rate:
Convertible notes accrue interest over time. This interest is typically added to the principal amount and converts into equity alongside the principal.
6️⃣ Maturity Date:
This is the date by which the note must either convert into equity or be repaid. If the startup hasn't raised a qualifying financing round by this date, the terms of repayment or conversion can vary.
7️⃣ Conversion Trigger Events:
Specific events trigger the conversion of the note into equity, such as a new equity financing round, acquisition, or IPO.
8️⃣ Simplicity and Speed:
Convertible notes are simpler and quicker to execute compared to traditional equity financing, making them attractive for early-stage startups needing fast capital.
9️⃣ Investor Protections:
Some convertible notes may include additional provisions like Most Favored Nation (MFN) clauses or pro-rata rights to protect investors' interests in future financing rounds.
