What is a convertible note in venture capital?
A convertible note is a type of investment startups use to raise money. It’s a loan that can change into part ownership in the company.
Convertible notes are loans
When a startup needs cash, it can ask investors for a convertible note. The investor gives the company money. The startup promises to pay the money back, plus interest.
Convertible notes can turn into part ownership
The cool part is the note can convert into shares in the startup. If the startup raises more money or gets bought, the note becomes part ownership. The investor now owns a slice of the pie.
Why startups dig convertible notes
Convertible notes are quick and easy. Startups get the money fast without tons of legal work. They don’t have to set a price on the company yet. That’s huge. It’s real hard for baby startups to say what they’re worth.
How convertible notes work
Flexible fundraising
A convertible note is a loan with a twist. The company and investor agree on the key points:
- How much moolah the investor lends
- The interest rate on the loan
- When the loan is due
- The discount the investor gets when the loan converts to stock
- The max value the startup will be worth when the note converts
Then they sign the deal and the money flows. Easy peasy.
Conversion triggers
Remember, the note turns into shares later on. That happens when the startup hits a target. Usually that’s raising a big chunk of change, called an equity round.
When the startup raises that equity round, the note converts. Poof! The loan becomes stock in the company. If the startup gets acquired, same deal. The note becomes equity.
Conversion math
So how much of the company does the investor get? That depends on the deal they made. Most notes have a cap and a discount.
The cap puts a ceiling on the share price the investor pays. Even if the new investors in the equity round pay more, the note holder gets the capped price.
The discount is a reward for investing early. It’s a percentage off the price of the shares in the next equity round.
When conversion time comes, the investor’s stock price is based on whichever is better – the cap or discount.
The pros and cons of convertible notes
The good stuff
Convertible notes are startup fundraising magic because:
- They’re fast. Not much negotiating or legal wrangling needed.
- They delay valuation. Startups can raise cash without setting a price tag. That’s clutch when a company is brand spankin’ new.
- Early birds get perks. Discounts and caps give investors props for jumping in first.
The not so good stuff
Hold up though. Convertible notes can have some gotchas.
- Debt is debt. It’s gotta be paid back, or the company is toast. Selling equity means no debt to repay.
- The interest piles up. Most startups don’t pay the interest in cash. It gets added to the loan amount, so the investor gets more shares later.
- You can’t raise too much. Convertible notes are for early funding. Raise too much and you’re in for a headache when it converts.
Flavors of convertible notes
Not all convertible notes are built the same. They’ve got different features.
Plain vanilla
A basic convertible note is a loan at a set interest rate. The loan converts to equity at a trigger event. Usually that’s an equity round or acquisition.
The share price is based on the cap, discount, or the price the new investors pay. Real simple.
Revenue share
Some wild convertible notes have a revenue share clause. The company pays the investor a chunk of their cash coming in. It’s another reward for betting on them early.
Interest-free notes
A few startups offer 0% interest convertible notes. The investors get their perks through the discount and cap instead. The company saves some cash by not owing interest.
SAFEs
A SAFE (simple agreement for future equity) is a twist on convertible notes. It’s not a loan. It’s more of a warrant to buy stock in the future.
With a SAFE, the investor coughs up the cash and waits. When the company raises a big equity round, the SAFE converts to shares. The price is based on the cap and discount in the SAFE.
SAFEs are even simpler than convertible notes. Startups like them because they’re not debt. No interest, maturity date, or need to pay it back.
