Convertible notes: Meaning, Criticisms & Real-World Uses

What Are Convertible Notes?

A convertible note is a short-term debt instrument primarily used by early-stage companies to raise capital from investors. As a key component of startup finance, it functions as a loan that includes the right for the investor to convert the principal and accrued interest into equity in the company at a later date, typically upon a future equity financing round. Until conversion, convertible notes are recorded as debt financing on a company's balance sheet.⁶³

History and Origin

The concept of convertible notes, or convertible debt, has roots extending back to the nineteenth century, predating modern venture capital funds.⁶² However, their widespread adoption as a preferred financing mechanism for early-stage companies gained significant traction in the 21st century, particularly with the rise of technology startups. This instrument provided a flexible way for companies to secure initial funding without undergoing a formal company valuation at a very early, often uncertain, stage.⁶⁰, ⁶¹ This deferral of valuation proved attractive for both founders and angel investors seeking to streamline the fundraising process and reduce upfront legal costs.⁵⁹ Recent market analysis indicates that while convertible notes remain a common tool, especially in bridge rounds, the terms are shifting in favor of investors.⁵⁸

Key Takeaways

Convertible notes are debt instruments that convert into equity, typically preferred shares, at a later financing event.⁵⁷
They often include a valuation cap and/or a discount rate to reward early investors for their higher risk.⁵⁵, ⁵⁶
Convertible notes allow startups to delay the complex process of valuation until a more mature funding round.⁵⁴
Unlike equity, convertible notes accrue interest rate and have a maturity date, although repayment in cash is rare for startups.⁵², ⁵³
They are a popular instrument for early-stage investing due to their simplicity and flexibility.⁵¹

Formula and Calculation

The conversion of a convertible note into equity can involve several factors, including the principal amount, accrued interest, a discount rate, and a valuation cap. The number of shares an investor receives upon conversion is generally calculated by taking the principal plus accrued interest and dividing it by the lower of two prices: the discounted price per share of the qualified financing or the price per share implied by the valuation cap.

Here’s a simplified illustration of how the conversion price (the effective price per share for the convertible note holder) is determined:

\text{Conversion Price} = \min \left( \text{Qualified Financing Price} \times (1 - \text{Discount Rate}), \frac{\text{Valuation Cap}}{\text{Total Pre-Money Shares in Qualified Financing}} \right)

Where:

Qualified Financing Price: The price per share at which new investors are investing in the subsequent equity financing round.
Discount Rate: A percentage reduction offered to convertible note holders on the qualified financing price, typically ranging from 15% to 25%.
*⁴⁹, ⁵⁰ Valuation Cap: A maximum pre-money valuation at which the convertible notes will convert, regardless of the actual valuation set in the qualified financing.
*⁴⁸ Total Pre-Money Shares in Qualified Financing: The total number of company shares outstanding immediately before the new equity financing round.

The number of shares issued to the convertible note holder would then be:

\text{Number of Shares} = \frac{\text{Principal Amount} + \text{Accrued Interest}}{\text{Conversion Price}}

Interpreting Convertible Notes

Convertible notes offer a nuanced balance between debt and equity. From an investor's perspective, they provide a level of downside protection similar to a traditional promissory note, as the loan can theoretically be repaid if the company fails to raise a qualifying equity round. However, the primary intent of investors in convertible notes is typically to convert the debt into an ownership stake, participating in the company's growth. T⁴⁷he presence of a valuation cap and a discount rate is crucial in interpreting the potential return for early investors, as these features provide a more favorable conversion price compared to later investors. For founders, using convertible notes allows for quicker fundraising rounds with less legal complexity and the strategic advantage of delaying a formal company valuation until the business has achieved more significant milestones.

⁴⁵, ⁴⁶## Hypothetical Example

Imagine "GreenTech Innovations," a new startup, seeks to raise seed funding. They decide to issue a $500,000 convertible note to an investor, "Apex Ventures," with an 8% annual interest rate, a 20% discount rate, and a $5 million valuation cap.

One year later, GreenTech Innovations successfully raises a Series A equity round at a pre-money valuation of $10 million, with new investors paying $1.00 per share.

First, calculate the accrued interest:
Principal: $500,000
Interest Rate: 8%
Accrued Interest = $500,000 * 0.08 = $40,000
Total Convertible Amount = $500,000 + $40,000 = $540,000

Next, determine the two potential conversion prices:

Discounted Price: $1.00 (Series A price) * (1 - 0.20) = $0.80 per share
Cap Price: If the $10 million valuation implies $1.00 per share, then a $5 million cap would imply a price of $0.50 per share (assuming the same number of pre-money shares).

Since the cap price ($0.50) is lower than the discounted price ($0.80), Apex Ventures' convertible note will convert at $0.50 per share. This is because the valuation cap provides a "ceiling" on the effective valuation at which the note converts, benefiting the early investor.

⁴⁴Finally, calculate the number of shares Apex Ventures receives:
Number of Shares = $540,000 / $0.50 = 1,080,000 shares.

This example illustrates how a convertible note allows early investors to convert their investment at a more favorable price, thereby securing a larger ownership stake than later investors, compensating them for their initial seed funding risk.

Practical Applications

Convertible notes are predominantly found in the realm of startup finance, serving as a crucial instrument for companies in their nascent stages to acquire initial funding. T⁴², ⁴³hey are particularly favored for seed funding and bridge rounds, which are short-term financings used to "bridge" a company between larger equity rounds.

³⁹, ⁴⁰, ⁴¹Their practical applications include:

Early-Stage Fundraising: Startups often utilize convertible notes to raise capital quickly and efficiently, bypassing the complex and time-consuming process of formal valuation negotiations when the company's future is still highly uncertain.
*³⁸ Bridge Financing: For companies that need additional capital between major funding rounds, convertible notes offer a flexible solution that can be implemented faster than a new equity round.
*³⁷ Attracting Investors: The inclusion of features like a discount rate and a valuation cap makes convertible notes attractive to angel investors and venture capital firms, rewarding them for taking on early-stage risk.
*³⁵, ³⁶ Strategic Flexibility: Founders can focus on product development and market traction rather than extensive fundraising efforts, knowing that the conversion terms will be set by a future, more established financing round.

³⁴For example, a company like Local Bounti recently secured additional financing through a $10 million convertible note with existing investors, featuring a 5-year maturity date and a 6.0% annual interest rate payable in kind. A³³dditionally, the issuance of convertible notes in the U.S. capital markets falls under the purview of federal securities laws, with regulations such as SEC Rule 10b-5 requiring full disclosure to investors.

³²## Limitations and Criticisms

Despite their popularity, convertible notes present certain limitations and potential criticisms for both founders and investors.

One primary concern for founders is the potential for unexpected dilution. While convertible notes delay a formal valuation, the terms agreed upon (such as the discount rate and valuation cap) can significantly impact the founders' ownership percentage once the notes convert. I³⁰, ³¹f the company's valuation grows substantially, early investors with low caps might receive a larger equity stake than initially anticipated, leading to greater founder dilution.

²⁹Another potential drawback is the debt component. Convertible notes carry a maturity date and accrue interest rate. W²⁸hile investors typically prefer conversion to repayment, if a qualifying equity round does not materialize before the maturity date, the company may be obligated to repay the loan with cash, which could strain its financial resources and potentially lead to bankruptcy if funds are insufficient. T²⁶, ²⁷his debt obligation can create pressure on founders to secure a priced round, potentially at unfavorable terms, to avoid repayment.

²⁵Furthermore, the legal complexity of convertible notes, particularly regarding unclear terms and inadequate disclosures, can introduce risks. Disputes can arise if key elements like conversion mechanisms or interest calculations are not explicitly defined in the agreement. I²⁴nvestors rely on the information provided by issuers, and failure to disclose pertinent financial details can lead to significant liability for the issuing company. A²³ccurate tracking on the company's capitalization table can also be challenging until conversion, as the exact number of shares is unknown.

²²## Convertible Notes vs. Simple Agreement for Future Equity (SAFE)

Convertible notes and Simple Agreements for Future Equity (SAFEs) are both popular instruments for early-stage startup finance that allow companies to raise capital without an immediate valuation. However, they differ fundamentally in their legal structure and implications.

The key distinction lies in the debt versus equity classification. A convertible note is a loan and carries the legal obligations of debt, including potential repayment. A¹⁰ SAFE, conversely, is not debt; it is an agreement for future equity, designed to be simpler and founder-friendlier by removing the debt features like interest rate and maturity date. W⁸, ⁹hile convertible notes are often preferred by more traditional investors seeking debt protections, SAFEs have become increasingly popular, especially in pre-seed funding rounds, due to their streamlined nature.

⁷## FAQs

Q: Why do startups use convertible notes instead of selling equity directly?

A: Startups use convertible notes primarily to delay the complex and often contentious process of company valuation when they are very early stage and lack significant metrics. This allows them to raise capital more quickly and with less legal expense than a traditional equity financing round.

⁵, ⁶### Q: What happens if a convertible note reaches its maturity date and the company hasn't raised another funding round?
A: If a convertible note reaches its maturity date without a qualifying equity financing round, the company is technically obligated to repay the principal and any accrued interest rate to the investor. However, in practice, investors often agree to extend the maturity date or convert the debt into equity at a pre-negotiated price, as their primary goal is typically an equity stake rather than cash repayment from a fledgling company.

³, ⁴### Q: Do convertible notes dilute founders' ownership?
A: Yes, convertible notes do lead to dilution for founders and existing shareholders. While the dilution doesn't occur immediately upon issuance, it happens when the notes convert into equity. The terms of the convertible note, such as the discount rate and valuation cap, determine the conversion price, which in turn dictates the number of shares issued to the note holders and thus the extent of dilution.¹, ²