If you’re an early-stage founder looking to quickly and efficiently raise capital for your startup, the convertible note may be the perfect vehicle for getting your investment. A convertible note or convertible debt is a loan that can convert into equity when certain events occur. Until that point, a convertible note is simply a loan to the company that accumulates interest.
Convertible notes can be a great option because they:
- Are simple and fast
- Are familiar to lawyers and investors
- Delay valuation until the next financing round
Getting funding through a convertible note is more straightforward and quicker than trying to raise cash through an equity financing round. This is a great way to get your first funding in the door as you’re building out your minimum viable product.
When companies use convertible notes, they are taking on debt. This is a key difference between convertible debt and a Simple Agreement for Future Equity (SAFE). Convertible notes are loans that accrue interest and must be repaid if they don’t convert. In contrast, SAFEs do not accrue interest and usually don’t need to be repaid if they don’t convert.
The term sheet provides a summary of major deal points. Most negotiations between you and your investor will happen at the term sheet level. Once both parties are aligned on the term sheet, then counsel will draft the deal documents. Below are the key deal points below so you can step into the negotiations with confidence.
The Maturity Date is the deadline for repayment of the loan and accrued interest. It is usually between 18 and 36 months after signing the convertible note, though the timeline can be negotiated depending on the situation. Unlike a car loan or student loan, convertible notes don’t have set monthly payments. Instead, the company generally has to repay the full amount—the principal plus interest—at the maturity date if it does not convert first. With convertible notes, the clock is always ticking. Smart founders who decide to use a convertible note tend to set the maturity date well after their next planned fundraising round.
Usually, convertible note investors are not big banks or traditional investors. Often, they are individuals, such as angel investors, who strongly believe in your vision. In theory, they could force you to liquidate the company if you cannot pay the principal and interest at the maturity date. However, this rarely happens. Instead, the founder and investor typically negotiate terms to extend the maturity date of the loan. Nevertheless, you should not take these loans lightly.
The interest rate is the amount you pay the investor for using their money now to make your own money later—a simple interest rate, typically between 4% and 6%.
In a convertible note, the loan will convert into equity when you raise what’s known as a qualified financing. A qualified financing is equity financing (not a SAFE or Convertible Note round) above a certain threshold, usually $1 million. When you raise a qualified financing, the debt will convert into shares of preferred stock in your company.
But how will it convert? What’s the formula you will follow to make this conversion? The number of preferred shares that convertible note investors will receive depends on whether there is a discount and/or a cap.
The discount rate, typically 15% to 25% percent, gets applied to the per-share price of the new investor. For example, let’s say your convertible note had a 20% discount and the new investors are paying $1 per share. The convertible note investor will convert at $0.80 per share. This means that if the convertible note investor invested $100K, they would receive 125,000 preferred shares rather than the 100,000 shares they would have received if they invested in the qualified financing.
One of the most heavily negotiated terms in convertible notes is the valuation cap, sometimes called the price cap or simply the cap.
So what is a valuation cap, and why does it receive so much attention? A valuation cap is the highest valuation at which the debt may be converted into equity regardless of the actual valuation of the qualified financing.
The cap price per share is calculated by dividing the valuation cap by the number of shares your company has outstanding before the qualified financing. For instance, say your valuation cap on the convertible note is $10 million and your next round of financing puts your company valuation at $20 million. The convertible note investor will be paying half-price for shares relative to the new investors.
The cap is usually the most significant point of negotiation. If it’s set too low, the founder’s stake gets heavily diluted. If it’s too high, the investor loses out.
Many convertible notes have both a discount and a cap. When this is the case, the investor will convert whichever gives them the most shares in the company.
What’s Better for Founders: Discount or Cap?
Generally, the ideal situation for founders is for the convertible note to be uncapped and discounted. This rewards the convertible note investor for their early risk while avoiding the challenge of assigning an arbitrary value to the company, which could be too high or too low.
Some investors insist they will “never” invest in convertible notes without a valuation cap. In reality, the outcome depends on the bargaining power of the parties involved. An uncapped note at the pre-seed stage might indicate the company is attractive and has some leverage in negotiations, which can help attract better investors in later rounds of equity financing.
However, not every early-stage startup has investors knocking on its door. When faced with a valuation cap negotiation, founders should ensure that the valuation cap is set at an appropriate level—ideally at a level higher than the company could achieve if it were to do a priced equity round of financing.
A solid understanding of these terms will help founders collaborate with their legal advisors to secure an advantageous deal for themselves and their team. Check out this video to learn more. For a deeper dive, read this guide.