Convertible note: Meaning, Criticisms & Real-World Uses

What Is a Convertible Note?

A convertible note is a form of short-term debt that converts into equity at a later date, typically during a future financing round or a liquidity event. Primarily used within the realm of corporate finance, especially for startup funding, it allows companies to raise capital without immediately determining a precise valuation. This type of instrument functions initially as a loan with an interest rate and a maturity date, but it is designed with the expectation that it will convert into ownership shares rather than being repaid as traditional debt. The terms of a convertible note are structured to incentivize early investors by offering benefits like a discount rate or a valuation cap on the future share price.

History and Origin

The widespread adoption of convertible notes, particularly in the seed funding stage for startups, emerged as a pragmatic solution to the complexities of early-stage valuation. Historically, traditional equity rounds for nascent companies were time-consuming and expensive due to the need for immediate company valuation and extensive legal documentation. Convertible notes offered a simpler, faster, and more cost-effective alternative for securing initial capital, postponing the valuation discussion until a later, more established financing round. This flexibility has contributed to their growing popularity, with the value of convertible notes written by venture capital investors to startups seeing a significant increase from $2.5 million in 2021 to $120 million in 2022.⁸ Many successful companies, such as Airbnb, utilized convertible notes in their early stages to secure critical funding and scale their operations.⁷

Key Takeaways

A convertible note is a debt instrument designed to convert into equity at a later stage, commonly used by startups for initial funding.
It typically includes terms like an interest rate, maturity date, discount rate, and valuation cap to protect and incentivize investors.
Convertible notes defer the need for an immediate company valuation, simplifying early fundraising rounds.
Conversion into equity usually occurs upon a subsequent, larger funding round (e.g., Series A) or a sale of the company.
While offering flexibility, convertible notes can lead to investor dilution and potential complexities in future financing rounds if not managed carefully.

Formula and Calculation

The conversion of a convertible note into equity can be determined by a few key terms: the discount rate and the valuation cap. Investors typically benefit from whichever term provides them with a lower effective share price.

Let:

( \text{PI} ) = Principal Investment (original amount of the note plus accrued interest)
( \text{PPSR} ) = Price Per Share in the Qualified Financing Round
( \text{DR} ) = Discount Rate (as a decimal)
( \text{VC} ) = Valuation Cap
( \text{FVM} ) = Fully Diluted Valuation of the company in the Qualified Financing Round

The conversion price for the noteholder will be the lower of:

Discount Price: ( \text{PPSR} \times (1 - \text{DR}) )
Cap Price: ( \frac{\text{VC}}{\text{Fully Diluted Shares at Conversion (pre-money)}} )

The number of shares an investor receives upon conversion is calculated as:

\text{Shares} = \frac{\text{PI}}{\text{Conversion Price}}

For instance, if a convertible note has a 20% discount rate and a $10 million valuation cap, and the next equity round values the company at $20 million with a price per share of $2.00, the investor would calculate two potential conversion prices:

Discount Price: ( $2.00 \times (1 - 0.20) = $1.60 )
Cap Price: ( \frac{$10,000,000}{\text{Fully Diluted Shares}} ) (assuming shares correspond to the $20M valuation, the cap price would be lower than the discount price, e.g. if the pre-money shares result in a per-share value of $2, the cap effective price would be ( \frac{$10M}{\text{Number of Shares at } $20M} ), yielding a lower effective price per share for the investor).
The investor would convert at the $1.60 price per share, as it provides a greater number of shares.

Interpreting the Convertible Note

Interpreting a convertible note involves understanding its various components and how they interact to determine the investor's eventual equity stake. The core idea behind a convertible note is to bridge the gap between initial funding and a more substantial, priced equity round. Key elements to interpret include the principal amount invested, the interest rate (which accrues and adds to the conversion amount), the maturity date (when the note is due if not converted), and most importantly, the conversion mechanisms: the discount rate and the valuation cap.

The discount rate rewards early investors for their initial risk by allowing them to convert their investment at a lower price per share than new investors in a future equity round. The valuation cap sets an upper limit on the company's valuation at which the note converts, ensuring that early investors receive a significant ownership percentage even if the company's value skyrockets. The interplay between these two terms determines which one is more favorable to the investor at the time of conversion, typically leading to the investor receiving more shares than they would have if they invested directly in the subsequent round.

Hypothetical Example

Imagine "GreenTech Innovations," a nascent startup developing a new sustainable energy solution. They need $500,000 for initial product development and market research but are too early to establish a definitive valuation. They issue a convertible note to an angel investor, Sarah.

The terms of the convertible note are:

Principal: $500,000
Interest Rate: 5% per annum, simple interest
Maturity Date: 2 years
Discount Rate: 20%
Valuation Cap: $5 million

One year later, GreenTech Innovations successfully develops a prototype and attracts a Venture Capital firm for a Series A funding round. In this round, GreenTech is valued at $10 million, and new shares are priced at $1.00 per share.

First, calculate the accrued interest on Sarah's note:
( \text{Interest} = $500,000 \times 0.05 \times 1 \text{ year} = $25,000 )
Total amount for conversion (Principal + Interest) = ( $500,000 + $25,000 = $525,000 ).

Next, determine the conversion price using both the discount and the cap:

Discount Price: ( $1.00 \times (1 - 0.20) = $0.80 ) per share.
Cap Price: To find the effective price per share based on the valuation cap, assume the $5 million cap applies to the pre-money valuation of the Series A round. If the Series A priced the company at $10 million, the effective share price for Sarah under the cap would be ( $10,000,000 \times \frac{$5,000,000}{$10,000,000} = $0.50 ) per share.

Sarah's convertible note will convert at the lower of the two calculated prices, which is $0.50 per share.

Finally, calculate the number of shares Sarah receives:
( \text{Shares} = \frac{$525,000}{$0.50} = 1,050,000 \text{ shares} )

If Sarah had invested directly in the Series A round at $1.00 per share, her $500,000 investment would have yielded only 500,000 shares. The convertible note structure, particularly the valuation cap, allowed her to receive significantly more equity for her early investment and risk.

Practical Applications

Convertible notes are predominantly used in startup financing, offering a flexible instrument for early-stage capital raising. They are common in seed funding rounds, where establishing a definitive company valuation can be challenging or premature. This allows founders to secure necessary capital quickly, without the extensive legal and valuation processes associated with traditional equity rounds.⁶

In practice, a convertible note often functions as a bridge loan, providing capital until a larger, more formalized equity financing round, such as a Series A, occurs. The terms, including the interest rate, discount rate, and valuation cap, are negotiated to provide a benefit to early investors for the higher risk they undertake. These investors typically expect their convertible notes to convert into preferred stock in the subsequent financing round, rather than seeking repayment of the underlying debt.⁵ An actual example of a convertible note agreement can be found in public filings with the U.S. Securities and Exchange Commission (SEC), demonstrating their legal structure and typical provisions.⁴

Limitations and Criticisms

Despite their popularity and utility, convertible notes present certain limitations and criticisms. One primary concern is the potential for unexpected dilution for founders. While convertible notes defer valuation, the valuation cap and discount rate can still result in early investors receiving a larger equity stake than initially anticipated, especially if the company performs exceptionally well and its valuation significantly exceeds the cap.³

Another significant risk is the scenario where a startup fails to raise a subsequent equity round before the convertible note's maturity date. In such cases, the convertible note reverts to being pure debt, requiring the company to repay the principal and accrued interest. This can place a substantial financial burden on an already struggling company, potentially leading to its insolvency if it lacks the cash flow to make the repayment.² This situation can lead to complex negotiations between founders and noteholders, sometimes forcing a company into bankruptcy even if it has operational viability.

Furthermore, managing multiple convertible notes with differing terms (e.g., varying discount rates or valuation caps) can introduce complexity into a company's capitalization table and complicate future financing discussions. This can create a "liquidation overhang" where early investors might have a disproportionately high liquidation preference compared to their initial investment, potentially making subsequent equity rounds less attractive to new investors.¹

Convertible Note vs. SAFE

Convertible notes are often compared with Simple Agreements for Future Equity (SAFEs), as both are popular instruments for startup seed funding that defer valuation. The key distinction lies in their legal nature. A convertible note is legally a debt instrument; it has a maturity date and accrues interest, meaning that if it doesn't convert to equity by the maturity date, the company is obligated to repay the principal amount plus any accrued interest. In contrast, a SAFE is not a debt instrument; it is an agreement for future equity that does not accrue interest or have a maturity date. This makes SAFEs simpler and more founder-friendly by removing the debt obligation and potential for repayment. Both instruments typically include a discount rate and/or a valuation cap to incentivize early investors, but the fundamental difference in their legal classification as debt versus a purely equity-linked instrument is crucial.

FAQs

What happens if a startup doesn't raise another round before the convertible note's maturity date?

If a startup fails to secure a new equity financing round before the maturity date of a convertible note, the note typically becomes due and payable as debt. The company is then obligated to repay the principal amount plus any accrued interest to the investor. In some cases, extensions or renegotiations of the terms might occur, but the default outcome is repayment.

Do convertible notes have voting rights?

No, convertible notes typically do not carry voting rights because they are debt instruments, not equity. Investors holding convertible notes only gain voting rights once their notes convert into common stock or preferred stock in the company.

How do investors benefit from a convertible note?

Investors benefit from a convertible note primarily through the potential for a higher equity stake and a favorable entry price compared to later investors. The discount rate allows them to acquire shares at a reduced price, while the valuation cap ensures their conversion price doesn't exceed a predetermined maximum, protecting them from excessive dilution if the company's valuation significantly increases.