A convertible note is a hybrid of debt and equity, and it’s a popular form of financing for two main reasons. First, convertible notes are generally easy and cost-effective, because they require little negotiation and paperwork. Second, they allow the parties to put off valuation until a later time, which is useful, because accurately valuing a new company from the outset can be difficult.
Before you venture into a convertible note financing, it’s important to have a strong grasp of the terms of the note and how it will convert to equity.
The Key Parts of a Convertible Note Financing
A convertible note is a type of short-term debt or loan that converts into equity after a startup raises a pre-agreed amount of total financing. Holders of convertible notes are offered minimal protections, and only have a right to equity after the agreed conditions of the financing have been met.
The Debt Terms of a Convertible Note
Convertible notes have the same central features as all debt instruments.
- Principal – This is the amount of financing the investor is providing, memorialized as the principal amount of the note.
- Interest – Annual rates tend to vary over time, and you’ll agree to the interest rate for your note with your investor. Generally speaking, interest on a convertible note accrues over time and is either paid to the noteholder whenever the note is due to be repaid or convert, or becomes part of the principal balance upon conversion.
- Maturity Date – This is when the note becomes due for repayment on the demand of the noteholder. Typically, repayment dates are between one and two years after issuance. It can also be agreed that the entire series of convertible notes only becomes payable after maturity and once the majority of the noteholders demand repayment.
- Priority – Convertible notes are usually unsecured, and noteholders generally have the same priority as all other unsecured creditors, but greater priority than a company’s senior equity holders.
While the first three debt features are, to some degree, negotiable, most investors are less concerned with any of them than they are with the terms governing how the note will convert to equity. Generally speaking, neither party is expecting the note to be repaid; the entire transaction is based around the expectation that the note will convert to equity.
Terms Governing Note Conversion
The conversion terms are the essence of the entire arrangement and govern two of the most important aspects of the note: when the note will convert to equity and how much will be paid to the noteholder upon conversion.
There are typically three main events that will trigger a conversion:
- A Subsequent Equity Financing. The most common conversion event is the closing of a subsequent preferred stock financing that meets an agreed minimum threshold. Upon the subsequent financing, the principal and interest on the notes automatically converts into the shares of the same stock that’s sold in the subsequent financing.
- A Sale of the Company. If the company sells substantially all or all of its assets while the notes are still outstanding, many convertible notes provide that noteholders can elect to receive either the principal and the accrued interest on the notes (or some multiple thereof) or shares of stock in the sold company at a price discounted from what the acquirer is paying.
- Reaching the Maturity Date of the Notes. If the company hasn’t achieved the agreed-to financing by the maturity date, many convertible notes provide that the noteholder can either convert the notes into common stock at the valuation cap agreed to in the note, demand repayment of the debt, or keep the note outstanding. Most noteholders choose the last option. Occasionally, in a more company-favoring form of convertible note, the company may have the ability to force a conversion at maturity at an appraised valuation or at a low valuation set out in the note itself.
Once conversion is triggered, the big question becomes what price the noteholders pay for their equity (through discharge of the note’s balance). Convertible noteholders pay less than what new investors pay in the subsequent financing. The exact price is determined by two factors, known as the discount rate and the valuation cap.
- Discount Rate. Holders of convertible notes are given a discount from the price paid by the stock purchasers in a subsequent financing in order to reward them for taking on the increased risk associated with early-round financing. Discount rates tend to vary between 10-30%, and commonly sit right at 20%. In some instances, the agreed discount rate will increase as the time the note has been outstanding increases, providing for a smaller discount if the subsequent financing happens quickly, and a greater discount if it takes longer.
- Valuation Cap. In most cases, convertible notes include a valuation cap, which is a certain threshold at which conversion can be triggered, in order to prevent the initial investors’ interest from being diluted if the company turns out to be unusually valuable. The cap sets the maximum price at which the notes can convert. When valuation caps are present, the notes will convert at the lower of either the price of the shares in the subsequent financing (with the agreed discount rate) or the value determined by the valuation cap.
Convertible notes can be a great way to structure your initial round of financing. Understanding the key terms in a convertible note financing will help you be able to effectively utilize this popular financing option for startups and negotiate with investors.
© 2017 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.