A convertible note (also referred to as convertible debt) is a debt loan that converts to equity when a company reaches a certain milestone, usually the next round of equity financing. It is a common way for early-stage startups to fundraise.
Convertible notes are commonly used as it is less expensive for a company to fundraise using this method as legal costs for document creation are lower which is useful for smaller rounds of funding at earlier stages (before Series A).
The terms of the conversion to equity are spelled out in the convertible note agreement. These terms are designed to be more favorable to investors who purchase the convertible notes versus investors who invest during the later equity rounds.
Generally, convertible notes feature:
- Valuation Cap: the maximum valuation at which the note can convert to equity.
- Interest Rate: the annual rate at which the interest on the loan accrues.
- Conversion Discount: the discount that will be applied to the convertible note when it converts to equity.
- Term Length: maturity date or length of time (usually in months) by which the company has to either repay the loan or reach their milestone event.
For example, company ABC raises on a convertible note at a $4M valuation cap, a 4% interest rate, 24 month term length, and a 15% conversion discount. An investor invests $10,000 into company ABC. One year later, company ABC raises a round of equity at a $5M post-money valuation (the company’s valuation after raising a round of equity) and a price per share of $0.50. What does this mean?
Note: if there is both a conversion discount and a valuation cap, only the lower of the two discounts applies at conversion.
Calculate the 15% discount: If the 15% conversion discount is applied to $0.50 share price, the share price becomes $0.425.
Calculate the $4M valuation cap: if the valuation cap is $4M, multiply the price per share by the valuation discount (valuation cap divided by pre-money valuation). Therefore, the share price is actually $0.40.
Based on the above, the valuation cap would be applied to noteholders. As an investor, your $10,000 has accrued 4% interest on your loan, meaning the outstanding loan amount is $10,400. You can now purchase $10,400 of shares at $0.40 per share totaling 26,000 shares.
Other Convertible Note Terms:
Below are some other terms related to convertible notes that you should be aware of as you review investment opportunities on Crowdfunder:
- Warrant Coverage: a feature of a convertible note that gives the investor the right to purchase additional shares in a company. This is represented as a percentage of the loan amount plus accrued interest.
- SAFE (Simple Agreement for Future Equity) Agreements: a commonly used type of convertible note, or in this case convertible equity. SAFE agreements do not have term lengths or interest rates as it is a future promise of equity, not a debt loan. Often they only have a conversion discount and/or valuation cap.
Convertible notes may be difficult for first time investors to comprehend; however, they have a large advantage for early-stage investments in the form of discounts to future valuations.
We’re here to help, if you have questions about using convertible notes, reach out to our Support Team.
Disclaimer: The terms highlighted herein do not reflect a complete description of the use or definition of the terms. These terms reflect a general use and understanding to the best of our knowledge. Any investor is encouraged to seek further information as we are not offering any legal, financial or accounting advice. Investing can cause the entire loss of principal and performance of any company is not guaranteed. This information is not an offer to buy or sell any investment, whether on Crowdfunder or another platform. All information herein is for informational purposes only.