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Convertible note

Convertible note

A convertible note is a form of short-term debt that converts into equity in a company upon a triggering event such as a future round of financing. It is often used as a bridge investment to collect funding while delaying valuation and dilution.

Introduction

Convertible notes are debt instruments which convert to equity upon completion of a triggering event such as a future qualified financing round. Convertible notes are a popular investment vehicle for early stage startup companies. They are simple, cheap, and fast compared to traditional equity financing rounds and do not require a company to determine valuation or dilution at that time.

Characteristics

Maturity date

Convertible notes, like other types of loans, have a maturity date at which time the loan repayment is due. Typical maturity dates are set between 18 and 24 months from investment.

Conversion milestone or trigger event

Various events can trigger the conversion of debt to equity. The most typical and advantageous for startup and investor is the initiation of a new round of equity financing. This financing round establishes a valuation for the company and the convertible notes are converted to equity at a discounted rate.

If the maturation date occurs before the next round of financing this leaves investors and the company with a variety of options:

  • Company pays back the principle of the loan plus interest
  • Investors extend the maturity date

The startup company often do not have the funds to pay back the convertible note loan plus interest and therefore would go bankrupt in this case. Thus investors and companies come to terms over extension or conversion in order to avoid this case. Conversion to equity prior to an equity round may not be favorable for the company.

Discount rate

Investors receive a discounted rate upon conversion to equity, for the risk taken on in the intervening time period.

Valuation cap

The valuation cap is a predetermined maximum valuation of the company at which the convertible note investment can be converted into equity .

Interest rate

The interest rate determines the amount of interest accrued on the note prior to conversion or repayment.

Alternative investment vehicles

Paul Graham declared in a tweet in August 2010 that convertibles notes had overtaken other types of early investments. Y Combinator later released the SAFE (simple agreement for future equity) as an alternative to traditional convertible notes.

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Further reading

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Aaron Kellner

Convertible Note | Examples and How It Works

Adam Lieb and Joe Wallin

What is a Valuation Cap?

Babak Nivi

Should I raise debt or equity?

FoundersClub

Convertible Notes

Fred Wilson

Convertible and SAFE Notes

Fred Wilson

Some Thoughts On Convertible Debt

Microventures

The Rise in Popularity of Convertible Notes

Ryan Roberts

Convertible Note Maturity Date Terms

Ryan Roberts

Convertible Note Interest: What is the Range?

Seth Levine

Has convertible debt won? And if it has, is that a good thing?

Yoichiro (“Yokum”) Taku

What happens to the convertible promissory note if the maturity date is reached and there hasn’t been a financing?

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