Convertible Notes Explained
Learn.angelist.com explains that convertible notes are “short-term debt instruments that convert to equity upon a predetermined conversion event.”
Convertible notes, along with SAFE notes, are one of the most common ways for startups to secure early-stage funding. According to the Angel Capital Association, 37% of angel deals in 2019 were accomplished with convertible notes.
How Convertible Notes Work
In a nutshell, here’s how convertible notes work.
First, an investor offers a convertible note to a founder, who in turn promises the investor equity in the company at a future date upon a “conversion event.” Until the conversion event occurs, the convertible note is just like traditional debt; it carries interest and has a maturity date.
“If the company does experience a conversion event, the total amount converting into equity will include the original principal amount on the note and any interest accrued to date,” learn.angelist.com explains.
At that point, one of two things determines the price at which the convertible note converts to equity: the valuation cap, or the discount rate if there isn’t a specific valuation cap. If a convertible note specifies both, the lower of the two usually applies.
Example of a Convertible Note
A founder raises $2 million by issuing convertible notes that have a valuation cap of $10 million. The convertible notes mature in three years and carry an interest rate of 5%. If the founder later raises $4 million in a Series A round with a post-money valuation of $20 million, this means the convertible note holders were able to acquire their 20% of the company for half of what the Series A investors paid.
Convertible Notes vs. SAFE Notes
Startups can use both convertible notes and SAFE notes to secure early-stage funding. In addition, both instruments offer future equity to investors for money upfront, and both convert into shares of preferred stock when a “triggering event” like a series A round occurs.
However, there are significant differences between convertible notes and SAFE notes. In particular:
- Convertible notes are considered debt, and SAFE notes aren’t
- Convertible notes have maturity dates, and SAFE notes don’t
- Convertible notes carry interest, and SAFE notes don’t
- Convertible notes usually involve more paperwork than SAFE notes
In addition, unlike a SAFE note, a priced equity round doesn’t necessarily constitute a conversion event for a convertible note; the latter can specify additional criteria for which priced equity rounds trigger a conversion.
Pros of Convertible Notes
Convertible notes have a number of advantages when it comes to raising funds for your startup.
They’re Simpler Than Equity
Raising convertible notes is easier – and thus faster and cheaper – than raising equity. The primary reason is that the parties are leaving some of the most difficult aspects for the future, such as operating agreements, shareholder agreements, etc.
They Delay Valuation
Early-stage companies that don’t have much of a track record can use convertible notes to attract investors with the prospect of a discount on a future valuation based on the company’s potential for high growth.
Cons of Convertible Notes
Convertible notes also come with risks and downsides that founders should carefully consider before using them to finance their startups.
They’re More Complicated Than SAFE Notes
Although convertible notes are simpler than many equity financing arrangements, they require considerably more paperwork than SAFE notes. This makes them more time-consuming to issue and more difficult to negotiate. And unlike SAFE notes, convertible notes have deadlines and interest payments to deal with. For these reasons, many founders prefer SAFE notes when it comes to raising funds for their startups.
You Might Not Raise Future Equity
If you’re unable to raise future equity, you probably won’t be able to repay convertible notes that mature. This is obviously a major problem for both the company and its investors.
You Might Lose Out Financially
Because convertible notes give away future equity in your company, there’s a risk that this equity will be worth a lot more than the value of the original loan, especially if you grow at a faster rate than expected.
Convertible Notes: Legal & Tax Considerations
Before issuing convertible notes, we suggest hiring an attorney with appropriate experience so you don’t run afoul of securities laws. They can advise you on matters such as how convertible notes are treated, how they are triggered, and what your legal rights and obligations are.
Other key considerations for startups regarding convertible include whether:
- You’ll be paying too much in interest, which could limit your cash flow
- You’re giving up too much equity compared to the eventual valuation in the future priced equity round
- You have too many convertible notes with different terms, which might overcomplicate things and deter future investors.
Whether you run a startup or an established business, we also suggest retaining an attorney to go over the tax implications of convertible notes.
“Convertible notes can be classified as either debt or equity for U.S. tax reporting purposes, depending on the facts and circumstances,” according to AngelList. “In practice, most convertible notes are treated as debt, but it’s always advisable for companies to consult a U.S. tax advisor when classifying these instruments for reporting purposes.”