What is a “convertible note”?

What is a convertible note and how does it work?

Convertible notes are debt instruments that include terms like a maturity date, an interest rate, etc., but that will convert into equity if a future equity round is raised. The conversion typically occurs at a discount to the price per share of the future round.

What is the purpose of a convertible note?

A convertible note is a debt instrument often used by angel or seed investors looking to fund an early-stage startup that has not been valued explicitly. After more information becomes available to establish a reasonable value for the company, convertible note investors can convert the note into equity.

Do you have to pay back a convertible note?

Convertible notes are just like any other form of debt – you’ll need to pay back the principal plus interest. In an ideal world, a startup would never pay back a convertible note in cash. However, if the maturity date hits prior to a Series A financing, investors can choose to demand their money back.

What is a convertible note example?

A convertible note is a form of short-term debt, typically issued to investors of a company in exchange for stock at a later time. For example, it may be debt that automatically converts into shares of preferred stock upon the closing of a financing round.

Why would a company pay off convertible debt?

Companies use convertible bonds to help lower borrowing costs. Convertible bonds have value added into them because they’re basically bonds with stock options. In the end, investors make interest on the bond’s original amount.

What happens when a convertible note converts?

Typically, the result is that the amount will convert to shares. If the convertible notes convert into shares, the company will need to determine how many shares to issue to the noteholder. To do so, the company will usually divide the loan amount, plus any accrued interest, by a certain share price.

How is convertible debt safer than equity?

The convertible note and the SAFE work very similarly. The difference is that the convertible note is a debt instrument (or loan) that converts to equity. The SAFE simply provides the right to purchase equity at a capped price (possibly with a discount) during a future equity funding event.

Do convertible notes dilute shares?

In the absence of protections, convertible bonds almost always dilute the ownership percentage of current shareholders. The result is that stockholders own a smaller piece of the pie after bondholders convert their holdings.

Why do startups use convertible notes?

The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.

What is a 20% convertible note?

For example, if the investors in a $500,000 convertible note seed financing were granted a discount of 20%, and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price (referred to as the “conversion price”) of $0.80 per share and thus receive 625,000 …

How do convertible notes affect stock price?

Most issuers hope that if the price of their stocks rises, the bonds will be converted to common stock at a price that is higher than the current common stock price. By this logic, the convertible bond allows the issuer to sell common stock indirectly at a price higher than the current price.

Are convertibles a good investment?

Convertibles are ideal for investors demanding greater potential for appreciation than bonds provide, and higher income than common stocks offer. Convertible bonds, for instance, typically offer a lower coupon than a standard bond.

Why do investors buy convertible bonds?

Convertible bonds typically carry lower interest rates payments than straight corporate bonds—the savings in interest expense can be significant. Investors accept the lower interest payments because the conversion option offers the opportunity to benefit from increases in the stock price.

Can you sell a convertible note?

One traditional way for startups to raise seed financing is to sell convertible notes (also referred to as convertible promissory notes). These seed financings are known as convertible note financings.

What happens to convertible note if company is acquired?

The most company friendly terms call for the note to be repaid with interest to the investor. Most convertible notes call for the note to be converted to common shares in the company at a pre-set price just before the acquisition/merger, often at the same price as the cap of the note.

What happens if a convertible note matures?

Most convertible notes, like other forms of debt, provide that they are due at the maturity date, usually 18 to 24 months. Occasionally, convertible notes will provide that at maturity they automatically convert to equity, or convert to equity at the option of the lender.

How do convertible notes convert into equity?

A convertible note is a way for seed investors to invest in a startup that isn’t ready for valuation. They start as short-term debt and are converted into equity in the issuing company. Investors loan money to the startup and are repaid with equity in the company rather than principal and interest.

Is a convertible note debt or equity?

A convertible note is a short-term debt that eventually converts into equity. Convertible notes operate as loans and are typically issued in conjunction with future financing rounds.

Is a convertible note a loan?

Within venture capital financing, a convertible note is a type of short-term debt financing that’s used in early-stage capital raises. In other words, convertible notes are loans to early-stage startups from investors who are expecting to be paid back when their note comes due.

How is SAFE different from convertible note?

A convertible note is debt, while a SAFE is a convertible security that is not debt. As a result, a convertible note includes an interest rate and maturity rate, while a SAFE does not. A SAFE is simpler and shorter than most convertible notes.

Do investors prefer SAFE or convertible note?

Convertible notes are more familiar to most investors. A well-known Silicon Valley tech accelerator created SAFE notes, so Silicon Valley investors are likely to be more comfortable with them.

What is the cap on a convertible note?

A convertible note cap sets a maximum valuation at which the investment made via the convertible note can convert into equity. Investors in the convertible note typically get converted at the lesser of the valuation of the next qualified priced round and the cap.