The Basics of Convertible Notes
By Blake Hart
Whether you are running a startup or investing in one, understanding what a convertible note is, and how a convertible note works, is critical. The convertible note is a favorite investment vehicle for many founders and investors alike and a great tool for early-stage investments and bridge rounds in between later stages.
This post outlines the key terms and explanations with regard to raising capital through or investing via a convertible note.
What is a Convertible Note?
A convertible note is a short-term debt instrument that later converts into equity. This type of investment effectively delays requiring a company valuation in calculating the amount of equity the company will give up. It is often used at a time when the valuation might be uncharacteristically low or there are not enough data points to accurately determine.
There are three primary benefits of a convertible notes:
- They simplify negotiations because you do not have to set a valuation—only a Valuation Cap, nor decide upon a host of other common preferred equity terms.
- They require less legal documents than do equity investments, saving time and money spent on attorney fees.
- They convert into the next round of financing, which can reduce friction that may accompany early equity rounds during a later round of financing.
Further, there are two benefits for investors – (1) convertible notes earn interest, and (2) they are debt (at least initially), which is good for investors because debt is senior to equity in the capital stack.
Is a convertible note an instrument of debt or equity? In a round-about way, the answer is both. Structured as a loan (which we would otherwise recognize as debt), the convertible note ultimately promises an equity interest upon conversion. This is beneficial for startups in particular, because early-stage company valuations can be difficult to set. The reality that they are often based on qualitative values and intangibles can lead to a gap between founder desires and investor offers. Addressing that gap can be tense and unproductive. Early valuations are key for founders because basing the equity calculation off of a low valuation means giving up a bigger piece of the pie. But valuations must be reasonable to attract investors.
Well, a convertible note allows the company the opportunity to reach a favorable valuation (at least up to the agreed upon cap), but also can benefit the investor if the company receives a lower valuation at the next financing round. Generally convertible note conversion occurs after a specified amount of time or upon reaching a funding round of a certain size. Most often the outstanding balance of the “loan” (i.e. the convertible note) automatically converts into equity when a company raises a certain amount at a specified value in a later funding round, but there could be other conversion events.
So why would an investor take the risk of investing in a startup via a convertible note? In sum, there are two sides to the benefit of convertible note. Sure, it gives the company time to reach a more favorable valuation, but convertible note investors benefit by accruing interest, conversion caps and discounts, and the debt nature of the security.
Convertible notes typically earn 6% to 8% interest per year. Secondly, a convertible note Valuation Cap means that if a startup really takes off and the valuation skyrockets at the next equity financing round, the convertible note investor will convert in at a capped valuation, or a discount (20% is standard) to the next round price.
For example, assume a convertible note investor invested $100,000 into ACME Inc. and received a $5M cap, 6% interest, and a 20% discount. One year later ACME Inc. is raising a Series A round of capital at a $15M valuation. The convertible note investor would convert $100,000 into the Series A round (or essentially purchase $106,000 worth of Series A shares) but at a price per share calculated using the lower of a $5M valuation or 20% off the Series A price.
Put simply, the equity the investor stands to receive is made greater as the result of a discounted share price or maximum valuation used in calculations at conversion. As a result, the investor secures a greater amount of equity than it would otherwise receive if buying into the round and triggering conversion.
Key Terms & Explanations
The titles and structure may vary, but generally the following key term (and other) categories are present in a convertible note:
Investment and Purpose
The “Investment and Purpose” section identifies how much is being invested and what the investor gets in return. Additionally, it is not uncommon for a convertible note to include a section identifying how the funds may be used. For example, the purpose of the funds might be limited to operational expenses of the company, to develop a specific technology, or to fund a specified marketing campaign. A company might want more control or flexibility as to how the funds will be used, but a more sophisticated investor might demand the comfort of limiting use to a specific purpose. For instance, an investor likely doesn’t want her funds being used to increase the founder’s salary or buy fancy office furniture. This is a point of negotiation.
Upon executing the convertible note, the investor pays the investment amount which the company may then use for its intended purpose.
Notes accrue interest starting from issuance until conversion (or repayment), which increases the value of the investment. In some cases, the company may choose to pay the interest directly to the investor, but it is more likely that the interest is added to the investment amount and later converted accordingly. We typically see 6% to 8% interest on convertible notes.
As the name may indicate, a convertible note’s “conversion events” section is one of utmost importance. This part of the agreement tells the investor when its short-term debt will convert into tangible equity. Similarly, this section tells the company when it is expected to make good on its promise and move the investor to the ownership column of its cap table.
So, what constitutes a “conversion event,” and how does conversion work? Generally, conversion events are separated into the following three categories:
- A qualified financing round
- A change of control, or exit event
Each individual category operates independently and sets its own conversion terms. Let’s consider each:
Most commonly conversion will occur as the result of a qualifying round. A qualifying round is an equity financing (almost always “preferred equity” financing) in which company shares (or other equity interests) are sold in exchange for capital. This section will likely also set a minimum size of such qualifying round, so that the conversion will only occur if the company is raising an amount of capital above a particular threshold. For example, in order to be considered a qualifying round the note may require that the company be seeking to raise a minimum of $1,000,000. Therefore, a raise of $750,000 would not trigger conversion and the convertible note holder would have to wait. If a qualifying round occurs, the outstanding balance (the initial investment plus interest) is divided by the unit or share price calculated using the lesser of the convertible note Valuation Cap, or discount.
Change of Control or Exit Event
When a company is sold, either via the sale of all or substantially all of its assets or shares, or through an initial public offering (IPO), a change of control (or exit) event may trigger conversion. If change of control triggers conversion, the conversion calculation generally requires dividing the outstanding investment amount (the original amount plus interest), by the price per common unit or company share offered in the change of control event. The other event that may happen upon a change of control is a repayment of a multiple of the note (usually 1.5x or 2x) to the investor.
What if the company fails to enter into a change of control event transaction or qualifying round? Can the convertible note just sit on the company books forever? Not likely…but only as a result of the maturity provisions. The maturity date identified in the note sets a future date triggering conversion if the date is reached and the notes have not yet converted (or money has not been paid back). Furthermore, the company or investor may want the option to elect for repayment rather than conversion; however, the reality is that most startups don’t have cash on hand to repay a note at maturity. We see a lot of workouts between investors and companies at maturity if the note has not yet converted. Either side may negotiate such an option, and while maturity might be included as a conversion event, it may simply set a date of mandatory repayment. If the maturity date triggers conversion, calculations involve dividing the outstanding note balance amount (including interest accrued) by a set conversion cap, usually one lower than the qualified financing conversion cap.
Now we know when conversion will be triggered, but how will it be calculated? When a conversion event occurs, the investor receives the number of shares equal to their investment amount (including interest) at a discounted “Conversion Price.” The Conversion Price is usually the lower of (a) the price determined by the Valuation Cap (see below), and (b) a discount (say 20%) off of the “qualifying round” price. As touched on above, the discount rewards the investor by discounting the share price and thus giving the investor a better price, or more shares, than investors investing the same amount in the qualifying round.
Another negotiable point is the “Valuation Cap.” Will the note even have a Valuation Cap, and if so, how much will it be? Some investors may require a Valuation Cap, which sets forth the highest valuation that will be used to calculate the investor’s Conversion Price. This means that even if the company is valued above the Valuation Cap at the next capital raise, the investment will convert according to the capped amount, and thus the investor will receive a greater portion of equity than if the actual valuation variable was used. For example, if the investor invested $1 million, the post-money valuation cap was $10 million, but the company’s post-money valuation at the qualifying round was $12 million, the amount invested would convert into equity at the $10 million Valuation Cap (note that this simple example ignores a potential percentage discount off of the qualifying round in lieu of the Valuation Cap). This Convertible Note Model spreadsheet highlights some basic convertible note conversion mechanics.
The default events identify what happens if the company defaults. For example, if the company becomes insolvent, makes a misleading representation, or fails to pay interest as required by the note, the investor may demand immediate repayment. This portion of the convertible note also likely identifies the preferred status of the note upon default, so an investor has a clear understanding of where it lines up against other company debts. This information provides insight into who gets paid first if, for example, a company goes bankrupt.
Additional terms you will likely find (and negotiate) in navigating convertible note transactions, include:
- Investor rights provisions (this may also be an entirely separate agreement)
- Confidentiality (the parties can’t disclose the convertible note arrangement to others)
- Representations and warranties of both parties
Whether you are a founder exploring fundraising options or an investor looking to invest into startups, you should now have a better understanding of the general functionality and benefits of convertible notes. For a founder, this can be an extremely effective tool for ramping up business without giving up too much premature equity. Through convertible notes, the company may secure growth capital, thus increasing the valuation, before being required to immediately give up a portion of the company in exchange for capital. As an investor, the convertible note is a means of receiving enhanced value in exchange for investment in exciting new companies through the use of a discount and Valuation Cap.
While we have laid out the key terms and explanations, it is important to remember that convertible notes are highly-negotiable and we would love to help you explore your options and make sure you get the most out of your desired transaction. For more details, please check out our related podcast which reviews Chapter 8 of Venture Deals, and/or call a Vela Wood attorney to discuss.