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Convertible notes are one of the most common investment instruments when it comes to early-stage venture financing.
According to the Angel Capital Association’s 2020 Angel Funders Report, 37% of angel deals were done using convertible notes in 2019.
Given the prevalence of these instruments, it behooves investors to know how they work. In this guide, we’ll cover the mechanics of convertible notes, the benefits and considerations when using them, as well as how they compare to SAFEs.
Convertible notes—sometimes called convertible promissory notes—are short-term debt instruments that convert to equity upon a predetermined conversion event.
Investors offer founders convertible notes in exchange for equity in the company. At some later point, such as a future fundraising round or liquidation event (acquisition, IPO, etc.), those notes will convert to equity (in other words, an ownership stake in the company)—usually in the form of preferred shares.
So, is a convertible note debt or equity? It’s a little of both. Convertible notes are recorded as debt on the company’s balance sheet up until the conversion event. After conversion, they become equity in the company. As debt instruments, convertible notes also have a maturity date and can earn interest (two key differences with SAFEs, as outlined further down).
VCs use convertible notes for many of the same reasons they use SAFEs. Both forms of financing allow investors and founders to put off the question of valuation—often a point of disagreement between founders and investors—until a later date, so that companies can get funded sooner.
The mechanics of a convertible note depend on whether or not the company experiences a conversion event. In the absence of a conversion event, the convertible note functions like a traditional debt instrument, with an interest rate and a maturity date.
If the company does experience a conversion event, the total amount converting into equity will include the original principal amount on the note and any interest accrued to date. The price at which the convertible note will convert to equity will be determined by one of two things:
Some convertible notes will specify both a valuation cap and a discount rate. In this case, the note will typically convert at the lower of the two options—a favorable outcome for investors.
Keep in mind that, unlike SAFEs, not all priced equity rounds necessarily trigger a conversion. Convertible notes can have additional parameters around what qualifies as a priced equity round that triggers conversion, such as a specified minimum amount raised in the priced round.
For instance, if the convertible note term sheet stipulates that conversion will only happen if $2M or more is raised, but only $1M is raised, the convertible note would not yet convert to equity.
In the case of a liquidation event such as an acquisition, convertible noteholders usually have two options, depending on the negotiated terms.
Assume you’re a founder who has just raised $1M via convertible notes. These notes come with a valuation cap of $5M, a maturity date 2 years from now, and an interest rate of 5%.
One year in, you manage to raise a $2M Series A, with a pre-money valuation of $8M and a post-money valuation of $10M. How much equity do these noteholders get?
Post-Series A, both the convertible noteholders and Series A investors would each have 20% of the company. However, the convertible noteholders only had to invest $1M for that 20%, while the Series A investors had to invest $2M for the same 20%.
Here’s a simple formula you can use to gauge how much equity a convertible note would give you upon conversion:
Shareholding Percentage Upon Conversion = Convertible Note Amount / Valuation Cap
Further, the $50k in unpaid interest (5% on $1M over 1 year) accrued by the notes would also go towards the conversion.
SAFEs and convertible notes carry many of the same benefits for founders and investors; but there are also key differences that founders and investors should understand.
To learn more, read our guide to SAFEs.
Because convertible notes have maturity dates, a question that often arises is: What happens if a conversion event doesn’t happen before the maturity date? Does the convertible note have to be paid back?
In theory, because they are debt, convertible notes must be paid back. But in practice, this is rarely the case. If a startup fails to raise a priced equity round before the maturity date, it’s highly unlikely it will have the funds needed to repay the note principal.
In such a case, the convertible noteholders have several options:
Founders like convertible notes for several reasons:
Meanwhile, venture investors use convertible notes for their own reasons:
Investors should be aware that convertible note financing at later stages can be taken as a negative signal, implying the company was unable to raise a traditional priced funding round at a stage when valuations are common.
There are some key considerations for founders, too:
Convertible notes can be classified as either debt or equity for U.S. tax reporting purposes, depending on the facts and circumstances. In practice, most convertible notes are treated as debt, but it’s always advisable for companies to consult a U.S. tax advisor when classifying these instruments for reporting purposes.
Debt financing is and will continue to be a common investment approach for early-stage companies. Both founders and investors should thus have a firm grasp of convertible notes and their implications.
To learn more about how the various pieces we discussed would fit together in a single document, refer to Fenwick’s convertible note template.
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