An Introduction to Convertible Notes

Emerging Companies & Venture Capital

What is a convertible promissory note?

A convertible promissory note is a debt instrument that converts into equity of the issuing company upon certain events. Typically, a note would convert into equity in a subsequent equity financing round and perhaps upon the note’s maturity or a sale of the company.

Convertible notes also contain debt terms (such as interest rate, maturity date, etc.) and resemble traditional debt in many ways. An investor who purchases a convertible note is a lender of the issuing entity and is not entitled to stockholder rights (such as voting rights, dividends, etc.) until the note converts into equity.

Why would a company seeking to raise funds choose to issue convertible notes, rather than equity? And why would investors choose to participate in a note offering? The below summarizes some of the benefits, as well as key terms, of convertible notes.

What are the benefits of a note financing?

Convertible promissory notes can be attractive investment instruments for a variety of reasons. Unlike equity financings, note financings do not require companies and investors to negotiate a company valuation and resulting price per share. Rather, investors can invest a certain dollar amount (i.e., $200,000) and the equity stake represented by that investment will be determined later, at the time of the note’s conversion. Companies that have not yet completed a priced equity round may prefer a note financing to avoid getting locked into a valuation too early. Companies may also use a note financing to raise funds between priced equity rounds if valuation is uncertain, perhaps because of market volatility or because the company is nearing (but has not yet reached) a value-inflection point.

Typically, note financings are simpler (and therefore faster) to implement than priced equity rounds. In addition to avoiding a valuation negotiation, the parties can also skip negotiation of various stockholder rights and approvals, since the investors will not yet be stockholders in the company. Parties usually focus on a finite number of key terms, and there is generally less documentation required than with an equity round. The efficiency of a note financing is beneficial to a company that needs cash quickly – it can raise funds to meet short-term funding needs, and then be in a more stable position to focus on negotiating the terms of an equity round. Similarly, if a company only needs a limited amount of proceeds to meet funding needs, it may be preferable to issue notes and avoid the (potentially negative) optics of a smaller equity round. For reasons such as these, note rounds are often referred to “bridge” rounds or financings, as they can bridge a company’s funding needs between equity rounds.

Purchasers of convertible notes also benefit from this efficiency and receive lender protections while the notes are outstanding. A maturity date provides certainty around repayment and interest accrues while the note is outstanding. Additional protections (such as operating covenants or security interests) could also be negotiated, helping to reduce risk of an investment.

While there are many benefits of convertible notes, companies should be mindful that investors have an expectation that the notes eventually convert into equity. Repetitive bridge rounds may be efficient in some ways, but can lead to investor frustration if the company continually increases its debt obligations and the bridge notes start to look like a “bridge to nowhere”.

What are the common terms of convertible note?

Many terms of a convertible note are similar to those you’d see in traditional, non-convertible debt instruments:

  • Maturity Date: Often set to align with the company’s equity fundraising goals. The company wants a long enough term to allow it to reach its next equity round, but investors want to ensure its short enough to keep the company motivated to pursue that round.
  • Interest Rate: Tends to follow market standards, but may be higher in riskier investments or lower if investors are largely insiders or an equity round is imminent.
  • Default Events: May include failure to pay amounts due or entering bankruptcy, and perhaps company-specific terms (such as defaulting on senior, institutional debt).
  • Other: Convertible notes may include operating and financial covenants, and may be secured by assets of the issuing company.

A convertible note must also detail when it will convert into equity and how to determine the amount of equity to be issued:

  • Conversion Event: The company’s subsequent equity financing round is the most common trigger for conversion. Often, parties negotiate a minimum equity raise amount that would automatically cause conversion of the note into equity. Raises not meeting that minimum threshold may only convert if investors agree to conversion.
  • Discount Rate: The rate at which the outstanding principal and interest will convert into equity. Converting at a price per share that represents a discount to the price paid by cash investors is typical, as this incentivizes investors to participate in the note financing and rewards their earlier investment.
  • Valuation Cap: A valuation cap can be used instead of or in addition to a discount rate to provide some investor protection on the conversion price. The valuation cap imposes an upper limit on the valuation that can be used to calculate the conversion price. If a note includes a valuation cap of $20 million but raises funds in an equity round with a $30 million valuation, the note will convert at the price determined with a $20 million valuation.
  • Treatment at maturity or sale: Notes should also address what happens if the note matures or if the company has an exit event prior to note conversion. Alternatives could include repayment in cash, conversion into an existing class of stock, or, in the case of an exit, repayment with a premium.

The above list is not comprehensive and additional terms may be negotiated. Investors may request governance-related rights during the period the note is outstanding (board observer rights, financial information rights), to allow monitoring of their investment. Most-favored nation provisions can also ensure that the company does not issue convertible debt on more favorable terms while the note is outstanding.

About SAFE Financings

Convertible promissory notes are often compared with Simple Agreements for Future Equity (or “SAFEs”), as both instruments convert into equity at later dates. SAFEs often have conversion-related terms similar to those described above, and note and SAFE financings can both typically be implemented faster than an equity raise. However, there are key differences to consider when contemplating a note or SAFE financing transaction. SAFEs are not debt instruments and therefore do not include an interest rate, maturity date or other debt-like terms (security interests, seniority, etc.). Without a maturity date, there is no obligation for the company to repay the investment amount to the investor by a certain date, in the event conversion does not occur. The SAFE will not accrue interest while outstanding and therefore only the original principal amount converts to equity. Companies and investors should consider whether a convertible note or SAFE is better suited to the fundraising and investing goals of the parties.