Financing a startup or emerging company requires diligence and complex agreements to protect your company’s best interests. A convertible note investment is a form of debt financing, used by early-stage companies that are not yet ready for a priced-round financing.
Is convertible debt a better option for your business than a SAFE or other investment vehicle? While convertible notes were more common several years ago, over the past 5 years SAFEs have become the more prevalent vehicle used in early-stage and seed-stage financings.
What is a Convertible Note Investment?
A convertible note investment is a form of debt financing that is common for early-stage startups. While the goal of debt financing for the lender is typically repayment of principal plus interest, with convertible notes the goal is for the loan to convert into equity when the startup does a preferred stock financing. Interest is accrued, rather than paid out over a set schedule, and when the note converts, the accrued interest is also converted into equity. By converting the principal and interest into equity, the lender/investor can benefit from the potential for the equity to increase in value.
How Does a Convertible Note Investment Work?
A convertible note investment has conventional loan terms and a “conversion event.” The note will have an interest rate and a maturity date. To make the investment more attractive to the investor, the note converts at a discount. The discount could be based on a straight discount (usually 20%), or on a valuation cap.
For example, the investor may agree to lend you $100,000 at a 10% interest rate with a two-year maturity rate. If the startup does a Series A financing at the end of the first year, the principal and accrued interest – $110,000 total – will convert into equity, but at a discount to the price being paid by the new investors. For example, if the new investors are paying $1 per share, and the note converts at a 20% discount, the note will convert at $0.80 per share. This means that the $110,000 in principal and interest will convert into 137,500 shares of preferred stock, rather than 110,000 shares.
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Convertible Note Terms for Founders to Understand
Four terms that all investors and startups should know are:
- Discount rate: A discount on the share price of the stock, often 20% for early investors.
- Interest rate: Convertible notes carry interest, which is converted into equity on top of the principal investment. The typical interest rate will be between 5% and 10%.
- Maturity date: The date when the note is due, and the investor requires repayment. This will usually be 2-3 years out.
- Valuation cap: If there is a valuation cap, then the note will convert as if the valuation in the later equity financing is that number, rather than the actual valuation being used in the equity financing. Of course, this only works for the investor if the valuation cap is lower than the pre-money valuation.
When Does Convertible Debt Turn Into Equity?
A convertible note will convert at the startup’s next funding round where the startup issues preferred stock. It is also common to include provisions for the convertible note to convert upon a sale of the company.
What Happens if a Note Doesn’t Convert?
Your startup may not reach a conversion event before the note hits maturity. If this happens, the best path forward is to negotiate with the investor to extend the maturity date. Keep in mind that investors may demand that the discount be increased, in exchange for extending the maturity date. This problem is why startups generally prefer using SAFEs, which have no maturity date.
SAFE vs. Convertible Investment: Which Is Right for Me?
SAFEs and convertible note investment share many of the same advantages for founders and investors. However, there are key differences – most importantly, the maturity date and interest accrual. Convertible notes accrue interest and have a maturity date, while SAFEs do not.
Every startup is unique, with its own challenges and considerations.
Consulting with a professional experienced with negotiating and navigating SAFEs and convertible notes is key.
Kinetic Law has many years of experience advising startups on funding options.
Paul Spitz, founder of our firm, is a former CEO who understands the unique needs and pressures entrepreneurs face.
Contact us today to schedule a consultation and learn more about our services. Through our office in Cincinnati, we offer virtual services to clients throughout Ohio and California, including the San Francisco Bay Area, Silicon Valley, San Diego and Los Angeles.
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