What is a Convertible Note?

The climate is improving for startups as many things change in favor of entrepreneurs. One of the most important circumstances fueling startup growth in recent years is the rise of the convertible note, which is now the most popular form of seed financing. Below we’ll look at what a convertible note is, and why companies should consider using them.

A convertible note is a bond that the investor can later choose to convert into common stock. Startups often issue convertible notes during seed financing, when the company may be little more than a twinkle in a developer’s eye. This is great for entrepreneurs, since convertible notes have the advantage of allowing the parties to wait until later to determine a valuation for the company — which can be a tall order before the business is even off the ground.

With a convertible note, the company gets their money immediately, but the investor must wait to see how many shares the investment is worth. This is determined during the next round of financing: Series A. When the company has reached the point of raising Series A funding, it has been in existence for a while, which gives all parties the chance to crunch some real-world numbers and arrive at a valuation for the company.

Once the Series A investors have arrived at a valuation, holders of convertible notes will receive their shares at a discounted rate. This discount is one way seed investors are rewarded for taking the extra risk of betting on the company early, without as much proof that the business would succeed. The discount rate works as follows: If the convertible note has a 15% discount rate and the Series A investors pay $1 per share, the bondholder can convert their investment to stock at a rate of $.85 per share.

There’s another way that convertible notes can compensate seed investors for taking that additional risk: a valuation cap. This is the maximum price at which your investment can be converted into shares of stock. So, let’s say your convertible note has a valuation cap of $4 million, but the Series A investors later decide that the company is worth $10 million, and pay $1 per share. This means that you will be able to purchase your shares at the much lower rate of $.40 per share — the Series A valuation divided by the valuation cap. When converting a note into shares, the investor can choose either the discount rate or the valuation cap; whichever is more favorable to the investor.

Investors love convertible notes because their potential to be changed into equity represents a significant upside if the company experiences lots of growth. For this reason, the issuing party will often counterbalance that potential by offering a lower coupon rate than a similar, non-convertible bond might receive. This is favorable for the issuer, of course, because a lower coupon rate means that the issuer will make lower interest payments on the bond.

Another reason convertible notes favor startups: If the notes are converted to equity, the company is relieved of its debt, just like that. The only downside here is that the stock will become diluted, to some extent, with the conversion of the notes into shares.

For all the reasons above, entrepreneurs would do well to consider convertible notes during seed financing. Plus, they are a fast and often inexpensive way to raise money. A good corporate lawyer can help make sure you get through the process smoothly.