Convertible note basics

By Helen Reeves

For companies that are pre-product or pre-revenue, a convertible note can be a useful tool to raise capital while avoiding placing a premature valuation on the business.

A convertible note is simply debt that converts into equity upon the occurrence of certain events, most notably upon a future equity financing. From a business standpoint, investors in early stage companies invest through convertible notes because everyone expects that the company will eventually raise capital via a priced equity round. For this reason, convertible notes are sometimes referred to as “bridge notes”; this is because convertible note are really thought of as a bridge to the first/next equity financing.

In a convertible note round, investors sign a note purchase agreement and receive a convertible promissory note, evidencing their loan and providing for the following key terms:

  1. Qualified Financing: This term sets the threshold amount of money that must be raised by the company through in a future equity financing in order for the principal and interest due on the note to convert into the same equity issued in that financing. Since it will convert the notes, founders should ensure that the Qualified Financing threshold amount is an amount that will be financially meaningful to the business.
  1. Discount: What makes a convertible note investment attractive is that the amounts due on the note convert at a discount to the price being paid by new cash investors in the Qualified Financing. The discount will typically be the lower of either (i) a percentage of the price per share to be paid by the new cash investors (the “Discount”) or (ii) a price per share calculated based on a valuation of the company agreed at the time the note is issued (the “Cap”). Typical Discounts range from 10-20%, while Caps can vary.
  1. Change of Control: If the company is sold before a Qualified Financing takes place, a convertible note may provide that the amounts outstanding on the note will either: (i) convert into common stock at an agreed upon Cap immediately prior to the Change of Control (so that note holders can share in sale proceeds as common stockholders) or (ii) immediately become due and payable at some multiple (usually 2x).
  1. Maturity & Interest: Lastly, in order for a convertible note to be respected as debt by the IRS, it must have a date when it comes due for repayment and interest that accrues. Typical maturity dates for convertible notes are 18-24months, while typical interest rates range from 3-5% per annum.