What Is a Convertible Note?
A convertible note is a short-term loan that converts into equity at a future funding round. Learn the mechanics, terms, and when to use one.
Key Takeaways
- A convertible note is debt that automatically converts into equity when the company raises a qualifying round of funding.
- It allows startups and investors to defer the valuation discussion until the company has more traction.
- Key terms include the discount rate, valuation cap, interest rate, and maturity date.
How a convertible note works
An investor lends money to a startup with the agreement that the loan will convert into equity shares at the next qualifying funding round. Instead of repaying the loan in cash, the startup issues shares to the investor at a price determined by the new round's valuation, typically with a discount. This structure lets early investors fund companies before a formal valuation has been established.
Key terms explained
The discount rate, usually 15 to 25 percent, gives the note holder shares at a lower price than new investors pay. The valuation cap sets a maximum valuation at which the note converts, protecting the investor if the company's valuation rises significantly. Interest accrues on the loan and typically converts into additional shares. The maturity date is the deadline by which conversion or repayment must occur, usually 18 to 24 months.
Why startups use convertible notes
Setting a valuation at the earliest stages is difficult and often contentious. Convertible notes avoid this by deferring valuation to a later round when the company has more data points. They are also faster and cheaper to execute than a priced equity round, with simpler legal documentation. Many African startups use convertible notes for pre-seed and seed rounds for these reasons.
Risks and considerations
If the startup never raises a qualifying round, the note may reach maturity without converting. At that point, the investor can demand repayment, potentially forcing the company into insolvency. Founders should also understand how multiple convertible notes with different caps and discounts interact, as the dilution at conversion can be more significant than initially expected.