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The Basics of Convertible Notes

Startups can use convertible notes to raise funds quickly and affordably. The convertible note has been and is currently a key method entrepreneurs use to capitalize their startup ventures at seed stage. A convertible note (or a convertible loan) is a popular way for early-stage startups to raise capital.

What is a convertible note?

A convertible note essentially converts short-term debt into equity over a defined period of time. The process involves taking a ‘loan’ from VC’s or angel investors, without going into a lengthy negotiation for the issuance of preferred stock. Then, at a mutually agreed upon time in the future (usually when the startup raises its next round of funding) that debt converts to equity, and the initial investors are rewarded for their early investment with a discount on the share price determined in such a round.

How does a convertible note differ from convertible debt?

Although the notes are structured as debt, there is no real expectation that the loan will be repaid. Instead it is primarily designed to delay the conversion of the debt into equity until after the company is able to secure a Series A financing.

Convertible debt may need to be repaid (with interest), where a convertible note relieves repayment by providing the holder with equity in the company instead.

The conversion usually includes a discount (20-30%) from the price of the Series A. This discount serves to compensate the early investors for the greater risk they take by investing before a Series A is secured. This creates some conflicts of interest and therefore many convertible notes have a cap which shall apply if the company is very successful and raises a Series A at a high valuation.

Convertible notes with a cap

The convertible note system works and simplifies the process for both investors and startups at the early stage. However, in cases in which the startup does exceedingly well (i.e. doubles, triples its valuation in a short period of time at initial round of financing) the early stage investors will only get the initial discount provided for in the note, and in that sense will not benefit from the success of the company although they initially took all the risk.

In this scenario, problems arise if the note has no cap. For example, if an early stage investor invests $1M via convertible loan and is granted a 20% discount on the share price when the next round of financing closes, then the early stage investor will be happy if the shares are valuable and gaining value. However, if somehow, the price of a share balloons to five times its originally anticipated price, then at 20% discount, the early investor is not truly being rewarded for her initial investment and the greater risk taken at the more initial stages.
This is where the convertible cap comes in. Silicon Valley investors have come up with a solution to the convertible note challenge. Many early stage investors require that there be a “cap” on the valuation. In that situation, the loan will be converted in a maximum valuation that was agreed upon when the loan was granted (the cap: say $5M) even if the actual valuation of the first round of financing was much higher (say $50M); this cap basically prices the note and thus achieves the main goal of an equity round – pricing. This method aligns both the founders’ interests and the early seed lender interest such that both of them aim that the first round of financing shall be at the highest valuation possible.

When should a convertible note “mature”?

It is customary that the note shall mature within a year or two. As there is no real expectation that the loan will be repaid but rather converted, that maturity period should allow the new company to secure a new round of financing by the maturity date and convert the debt as part of such Series A transaction. Problems may sometimes arise when the company fails to raise a Series A round of financing during the maturity period. In such a case the company would need to negotiate the extension of the maturity of loan with the lenders or agree on some other form of conversion.

Do convertible noteholders have control over the company?

No. Some angel investors may ask for specific control mechanism, such as having a board member or such other “veto” rights, but these are usually rare. In most cases, the debt will automatically convert to preferred stock at the close of Series A financing at a discount.

Dilution of Convertible Notes

Since a convertible note method of financing is structured as a loan and not as an equity investment, some founders do not fully understand the dilution element associated with it.

While in an equity financing, the investor is issued stock against its investment at an agreed upon valuation, in a convertible note scenario, the investor is not issued stock and basically instead holds a contractual right to be issued stock once the conversion mechanism is triggered (which is usually defined as the “Next Round of Financing”). The number of investor stock to be issued in an equity financing is usually done on a “fully diluted basis” which means you take the number of all stock actually issued, or promised to be issued to employees and consultant or other warrant holders, and divide that by the agreed upon pre money valuation. That results in a “price per share”. That also means that any issuance of stock thereafter, or the grant of an option or warrant, dilutes ALL shareholders or optionholders at the company at that stage. (For more information please read “’Fully Diluted Basis’ – A Term Every Founder Should Know!”)

In a convertible note scenario, the investor was not yet issued stock and will be issued stock only when the next round of equity closes. This means that such investor will not be diluted for any issuances of stock that occurred after he made his convertible note investment, even if that investment was prior to the subsequent stock issuances. Founders should be aware of that.

Note however that it is possible to contractually take care of this scenario when the convertible note purchase agreement is negotiated. You can structure it such that the conversion will not take into account all of the Outstanding Common Stock in the applicable definition in the note agreement.