What Are Convertible Notes and How Do They Work?

If you’re a startup looking for funding, you may have encountered the term convertible notes. Convertible notes are a unique form of financing that is particularly popular with early-stage companies. They offer a flexible solution for raising capital without the need to set a precise valuation for your business right away.

In this guide, we’ll explain what convertible notes are, how they work, their advantages, and their disadvantages, so you can decide if they’re the right fit for your startup.

What is a Convertible Note?

A convertible note is a short-term debt instrument used by startups to raise capital. Essentially, it is a loan that converts into equity at a later stage, typically during a future financing round (like a Series A round). The key difference between a convertible note and a traditional loan is that instead of being paid back in cash, the loan amount is converted into equity (shares in the company).

Key Features of Convertible Notes:

• Debt Financing: Convertible notes are technically loans that are issued to the company by investors.

• Conversion to Equity: Instead of repaying the loan with interest, the amount loaned converts into equity (shares) in the company, usually at a discounted price.

• Conversion Trigger: The conversion typically happens when the company raises its next round of funding (e.g., a Series A round).

• Interest Rates: Convertible notes often include an interest rate, though this interest is usually not paid out in cash but added to the principal when it converts to equity.

How Do Convertible Notes Work?

1. Issuance of the Convertible Note: A startup issues a convertible note to investors in exchange for immediate capital. The note includes terms such as the loan amount, interest rate, conversion price, and conversion trigger (usually the next equity financing round).

2. Interest Accrues: Over time, the convertible note accrues interest. However, this interest is typically not paid out in cash but is added to the principal loan amount and converted into equity during the next funding round.

3. Conversion to Equity: When the startup raises a subsequent financing round, such as a Series A, the convertible note converts into shares of the company. The price per share is often discounted compared to the price paid by new investors, providing a reward for early investment.

4. Discount and Valuation Cap: Two common features of convertible notes are the discount rate and the valuation cap. The discount rate gives investors a percentage reduction (e.g., 20%) on the share price during the next funding round. The valuation cap sets a maximum price at which the note can convert into equity, protecting early investors from being overly diluted if the company’s valuation increases significantly.

Pros of Convertible Notes

1. No Immediate Valuation Needed

One of the key benefits of convertible notes is that they allow startups to raise capital without having to set a valuation for the company right away. This is particularly useful in the early stages when it’s challenging to determine a fair market value.

Why It Matters:

In the early stages of a startup, it’s often difficult to establish an accurate valuation due to the lack of revenue and operating history. Convertible notes allow startups to delay this decision until a later financing round when the company’s value becomes clearer.

2. Faster and Simpler Process

Compared to traditional equity financing, convertible notes are faster and simpler to execute. The terms are straightforward, and there’s no need to negotiate complex equity terms upfront. This makes convertible notes an attractive option for startups in need of quick capital.

Why It Matters:

Convertible notes save both time and money. Without the need for extensive negotiations over valuation, startups can focus on growing the business rather than getting bogged down by fundraising processes.

3. Attractive to Investors

Convertible notes are attractive to early-stage investors because they offer a discounted price on future equity and the potential for high returns once the company raises more funding. Additionally, convertible notes typically have higher interest rates than traditional loans, providing a small return even before the conversion.

Why It Matters:

Investors are willing to take on early-stage risk in exchange for the potential of significant rewards. Convertible notes offer an opportunity for early investors to acquire shares at a favorable price when the company raises its next round of funding.

4. No Immediate Repayment Obligation

Unlike traditional loans, convertible notes don’t require repayment in cash during the term of the loan. Instead, the loan converts to equity. This provides flexibility for startups that may not have the cash flow to meet regular loan payments in the early stages of growth.

Why It Matters:

This flexibility allows businesses to focus on growth and product development without worrying about making regular debt payments.

Cons of Convertible Notes

1. Potential for High Dilution

While convertible notes are non-dilutive in the short term, they can lead to significant dilution of ownership once the notes convert into equity. As new shares are issued to cover the conversion of the notes, existing owners may see their ownership percentage decrease.

Why It Matters:

If the company grows rapidly and raises large rounds of funding, early investors who hold convertible notes could receive a larger percentage of equity, diluting the ownership of the founders and existing shareholders.

2. Risk of Debt Conversion at Unfavorable Terms

If the startup struggles to raise a subsequent round of funding or does not meet its milestones, the convertible note may not convert into equity. In this case, the business may still be required to repay the loan, potentially creating financial strain.

Why It Matters:

While convertible notes offer flexibility in repayment, there is still the possibility that they could convert at unfavorable terms if the company’s valuation or financing round doesn’t meet expectations.

3. Potential for Complex Terms

Convertible notes may come with complex terms such as valuation caps, discounts, and interest rates. This can lead to confusion and require legal guidance to fully understand. Additionally, the terms of the note could be challenging if the company raises multiple rounds of funding.

Why It Matters:

The terms of the convertible note can significantly affect the final ownership percentage and repayment structure, so both startups and investors need to carefully review the terms.

4. Risk of Investor Expectations

Convertible note holders are often looking for high returns on their investment. If the company raises substantial funds at a high valuation, the investors may push for a larger share of the company, which could lead to conflicts between investors and the founders.

Why It Matters:

Managing investor expectations is critical for a healthy founder-investor relationship. Too much pressure from investors for an early exit or high return could impact long-term business decisions.

When to Use Convertible Notes

Use Convertible Notes If:

• You’re in the early stages of your business and need to raise capital without determining a valuation right away.

• You have strong investor interest but are not yet ready for an equity financing round.

• You need fast, flexible capital and want to avoid the complexities of traditional equity financing.

• You don’t want to give up equity at the early stages of your business, but you’re comfortable offering investors a future stake in exchange for early funding.

Conclusion

Convertible notes are an attractive financing option for startups looking to raise capital without immediately giving up equity or determining a business valuation. They offer flexibility, faster access to capital, and the potential for investors to benefit from future growth. However, they also carry risks, including dilution and complex terms, that startups must carefully consider before moving forward.

Ready to Use Convertible Notes for Your Startup?

If you think convertible notes are the right fit for your business, it’s important to work with an experienced financial advisor or legal expert to ensure the terms align with your goals. With the right approach, convertible notes can provide your startup with the capital it needs to grow.