What Is a Convertible Note?

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DEFINITION
A convertible note is a type of debt that can convert into equity at a future date.

A convertible note is a type of debt that can convert into equity at a future date. Convertible notes are typically used by new businesses or startups to raise funding when they may not be ready to make a public valuation.

Convertible notes provide a short-term financing method in which a business promises the funds will be repaid with interest, or the principal plus interest can be converted into shares of the company.

Let’s learn more about what convertible notes are, how they work, and about their pros and cons for businesses and investors. Also, before you decide to invest in a convertible note, learn what determines how investors receive shares.

Definition and Examples of Convertible Notes

A convertible note is a short-term debt agreement that allows funds from investors to eventually be converted into equity.

  • Alternate name: Convertible debt

A business in the early stages of development may use convertible notes when it needs financing. It can accept money from investors and repay it with interest, or offer to convert the investor’s principal plus interest into shares of the company. The shares are generally in the form of preferred stock, in which investors receive their pay before common stock.

Convertible notes are useful for new businesses because the notes don’t require the company to have an official valuation. They give the new business an opportunity to accept investors' funds and prove its net worth later.

For example, a startup may find it difficult to qualify for traditional lending. Traditional lending often requires terms that can be a challenge for new businesses to meet. It may have to prove the ability to repay the loan, have a certain business credit score, or be in business for a specified amount of time.

With the convertible note, the startup agrees to provide equity or repayment for the funds given by an investor with a promissory note.

A convertible note offers a faster process, without requiring much documentation or negotiation, and is an overall simplified process compared to other financing options. If you’re looking for a quick means for borrowing funds, a convertible note may be helpful. However, you should consult a professional who can help determine your business’s options before opting for a convertible note.

How a Convertible Note Works

Convertible notes work similarly to a loan and are used in the early rounds of financing for a business. The investor providing the funds acts as a lender. The convertible note agreement sets a maturity date, by which the business must pay back the loan with interest or give the option to convert the amount owed into equity.

A company’s valuation is not considered when the note is issued. When the shares are converted, they generally are converted at a price that is a discount to the company’s current market price that new investors are paying.

The terms are specified in the agreement in the promissory note, which is a document that contains the promise that the borrower will repay the lender. A promissory note used for a convertible debt agreement should contain all pertinent terms, conditions, and details concerning conversion, payment terms, amounts, maturity, and interest, among others.

Types of Convertible Note Key Terms

There are several key terms businesses and investors should understand before engaging in business concerning convertible notes, such as the discount rate, valuation cap, maturity date, and interest rate.

Discount Rate

Because convertible notes include risk to investors, companies offer a discount rate. The discount rate provides a lower rate per share compared to the regular price per share. Discounts often range between about 15% to 25%.

Valuation Cap

A valuation cap limits the price at which equity can be converted with a pre-money valuation.

When the note converts into shares, the investor can receive the shares equal to the pre-money valuation, regardless of what new investors are paying. When the price of conversion is determined, investors can opt to use either the discount rate or the valuation cap, but they generally don’t use both.

Maturity Date

Maturity date refers to the time at which the convertible note should be converted into equity for the lender, if the funds are not yet paid back. This date can be set either at just a few months or several years, with the average being about two years.

At the maturity date, the maturity date may be extended, or the lender can choose to request the equity, since the conversion is not automatically completed by reaching this point.

The convertible note can still automatically convert to equity if qualified financing meets the specified amount in the agreement. This means if the company sells shares of preferred stock at this amount, the equity automatically converts for the investor.

Interest Rate

Like traditional loans, convertible notes carry an interest rate that is applied to the principal amount. The interest rate often ranges from 5% to 12%, and unpaid interest also applies to the principal when the investor's funds are converted into shares.

Key Takeaways

  • A convertible note is a type of convertible debt that allows the conversion of borrowed funds into equity.
  • Convertible notes work similarly to loans, with the investor providing funds with the agreement that they will be repaid with interest, or that their funds will be converted into shares of the company.
  • New businesses, or startups, may use convertible notes in early financing stages, in part because they won’t be required to set a valuation.

Article Sources

  1. University of Pennsylvania. “Convertible Notes Overview.”

  2. Small Business Administration. “3 Ways To Get Working Capital for Your Business.”

  3. Carnegie Mellon University. “Convertible Notes.”

  4. University of New Hampshire. “Valuing Young Startups is Unavoidably Difficult: Using (and Misusing) Deferred-Equity Instruments for Seed Investing.”

  5. North Carolina State University. “Raising Angel and Venture Capital.”

  6. University of Michigan. “Understanding Convertible Debt – Michigan Law Entrepreneurship Clinic.”