Convertible Notes: What Are They and How Do They Work?
If you invest in early stage startups, you’re likely to see companies that offer convertible notes in exchange for your investment. Convertible notes have become a very popular way for startups to raise money in their early funding rounds for a few different reasons.
Let’s take a look at what convertible notes are, how they work, and the pros and cons of investing in them.
What Is a Convertible Note?
A convertible note is debt that can later convert into equity. Think of it as a loan: an investor loans money to a company, but instead of receiving their money back with interest, they receive equity at a discount instead.
This ability to “convert” into equity makes convertible notes unique. The point at which the debt converts to equity is known as a trigger, which usually happens when a company raises a new funding round.
Convertible notes are generally used only in a startup’s earliest funding round, when the “company” is really little more than an idea. A key advantage to offering a convertible note is that it allows a startup to delay putting a valuation on itself when there isn’t enough hard data to calculate a realistic figure, which is favorable for the founders of the business.
This way, startups founders can avoid valuing their business too low before they know what it’s really worth, thereby giving up more equity than they should have for the same amount of money.
By waiting to value themselves, they can simply take the cash to grow their business and reward an appropriate amount of equity down the line, when they know how much the business should be worth.
How Do Convertible Notes Work?
In most cases, the trigger for convertible notes is a future funding round. A startup that has put the cash from its convertible note investors to good use will have growth to show for it. In order to maintain or accelerate its growth trajectory, it will seek to raise additional capital based on its traction.
At this point, the business will more than likely sell equity, meaning the founders will have to set the startup’s valuation. This is when the initial investors with convertible notes will see their debt convert into equity.
Investing through a convertible note comes with risks. The investor won’t know when or even if there will be a future funding round that will trigger the debt to convert to equity, and they won’t know what the future valuation of the company will be. To counteract these investor risks, convertible notes come with some perks:
Preferred Stock
Convertible notes often convert to preferred stock, which can give investors additional protections from dilution and bankruptcy. In some cases, however, the debt will convert into common stock, which lacks those protections but also has voting rights in the business and is the same type of equity that the founders usually have. To get a better understanding of the differences, check out this article on preferred and common stock.
Discount Rate
Convertible notes often come with a discount rate that represents the discount on share price that investors receive when their note converts into equity.
For example, let’s say you lend a startup $10,000 and receive a convertible note with a discount rate of 20%. Two years later, that startup raises equity at $1 per share in the subsequent round, but with your discount, you would receive equity at $0.80 per share.
That means your debt would convert to 12,000 shares for your $10,000 investment, whereas a new investor investing the same amount would only receive 10,000 shares.
Valuation Cap
Convertible notes also frequently have a valuation cap, which represents the highest valuation at which convertible note holders will have their equity share determined.
For example, let’s say you lend a startup $10,000 for a convertible note with a valuation cap of $5M. Even if the company’s next financing round values the business at $10M, your note will convert to equity that represents 0.2% of the company (your $10,000 investment divided by the $5M valuation cap), rather than 0.1% ($10,000 divided by the $10M actual valuation). Note: combined with a discount rate, your equity share would be even greater.
The valuation cap protects the upside of early investors by preventing their riskier investments from being valued equally to later, safer investments.
Interest Rate
As with most debt, convertible notes often carry interest rates. However, rather than being paid back in cash for interest accrued on their convertible notes, investors will usually earn additional shares equivalent to the value of their interest in the subsequent round.
When combined with a discount rate and valuation cap, earned interest that converts to equity provides yet another perk that can offer more equity to early investors to offset the risk of the unknowns that come with convertible notes.
However, it’s important to note that not all convertible notes include these rewards – some may not have a valuation cap, discount rate, or interest rate – and which perks a convertible note has can change the attractiveness of an investment opportunity.
Maturity Date
Though the goal of investing in a convertible note is to earn future equity, in the case that a company doesn’t raise another round by a certain predetermined date (the maturity date) and hasn’t gone bankrupt, convertible note holders are entitled to the repayment of their principal, or initial investment, plus any interest accrued in cash.
Note: at StartEngine, convertible notes are structured differently and will not convert into cash at the maturity date. Instead, they will convert into equity at the maturity date, or at the time of a future financing round, whichever comes first.
Conclusion
Because they are simple to implement and don’t require founders to put valuations on their startups at an early stage, convertible notes are very founder-friendly methods for raising capital in early funding rounds. However, because convertible notes don’t grant immediate equity to investors, they are riskier investments. Many early-stage investors avoid them completely, seeking only equity investment opportunities.
If you are considering investing in a convertible note deal, the main questions to ask are:
- What type of equity would the debt convert into? Would you receive common or preferred stock?
- What is the discount rate? How much will your future equity be discounted because of the early risk you took?
- What is the interest rate? How much interest will you receive, and will you receive that interest in cash or additional equity?
- What is the valuation cap? What is the ceiling for the company’s future valuation if they do another funding round?
Of course, the more promising the underlying startup, the more likely you may be to concede on some of these points.
If you’re interested in investing in startups, head over to our explore page to see what’s new on StartEngine. While most companies on StartEngine offer equity and not convertible notes, there are a wide variety of investment opportunities for you to choose from and explore.
