What Is a Convertible Note and How Does It Work?

Article Table of Contents:

• What Is a Convertible Note?
• How Do Convertible Notes Work?
• Why Use a Convertible Note?
• Convertible Note Terms
• Who Should Use Convertible Notes?
• Pros and Cons
• Convertible Note Alternatives

If you’re an early-stage startup looking to grow quickly, finding the right form of financing is essential. Like many startups, you might decide to try and seek venture capital—especially if you have a big idea and are trying to implement your business plan quickly. If you are seeking venture funding, then one of your biggest looming questions is likely: What’s my company’s valuation?

After all, your company’s valuation will have a large effect on the kind of capital you’ll be able to raise and from whom you’ll be able to raise it. Unfortunately, valuation is a complex issue, which is why many startups who raise angel or seed capital choose to use convertible notes when engaging investors. A type of financing for early-stage companies, many startups use convertible notes before they pinpoint an exact valuation for their organization.

If all of this sounds a bit confusing, don’t worry—we’re here to help. In this guide, we’ll define convertible note, explain how convertible notes work for startups, and provide all of the information you need to decide whether this is a viable option for your business. 

What Is a Convertible Note?

Within venture capital financing, a convertible note is a type of short-term debt financing that’s used in early-stage capital raises. In other words, convertible notes are loans to early-stage startups from investors who are expecting to be paid back when their note comes due. But, instead of being paid back in principal with interest—as would be the case with a typical loan—the investor can be repaid in equity in your company.

You might also think of a convertible note like an IOU. An investor provides you with capital now and the convertible note, acting as a short-term loan, ensures that you give the investor a stake in your startup later. From the investor’s point of view, the benefit in this exchange is that if they give you capital and a vote of confidence early on and you do well, you’ll repay them many times over.

How Do Convertible Notes Work?

Typically, an investor will provide an early-stage startup in need of capital with a loan (with repayment terms in the ballpark of a standard short-term loan, usually a year or two), along with repayment terms. This is the “note.” The note will include a due date at which time it’s mature and the balance will be due, along with interest. Generally, however, the note is not repaid like a normal short-term loan. Instead, you repay the investor for their loan with equity in your company, usually in conjunction with another funding round. 

If, however, the maturity date comes along and your startup has not yet converted the note to equity, the investor can either extend the convertible note’s maturity date or call for the actual repayment of the note.

This being said, the whole idea behind convertible notes is that your company is on a strong growth trajectory and that is why the note is being issued—it amasses value for the investor and beelines to a priced round. Ultimately, the point of a convertible note is that the noteholder, or investor, doesn’t want to get their loan paid back— they want their debt to convert into a heavily discounted security in a successful, valuable company that’s growing extremely quickly.

Why Use a Convertible Note?

Startups and investors choose to use convertible notes because they’re simple and fast. Since convertible notes are a type of debt, they give you the ability to avoid the complications of a priced round where you actually issue shares of stock. If you were to opt for a typical funding round, you would need a valuation of your company—which, as we mentioned earlier, is not easy to come to.

In fact, it’s quite hard to come to, and whether or not you can even raise capital at all often hinges on whether you value your company correctly—in other words, whether you and your investors can agree on the valuation. This is particularly difficult if you’re in the very early stages of your startup—just incubating an idea, pre-revenue, or perhaps seeking financing to develop the technology on which your entire business will hinge—completing a valuation is nearly impossible.

In this scenario, therefore, convertible notes offer a large advantage. By using a convertible note, you and your investors can determine your valuation at a later time when you have concrete data like growth numbers, sales, and customers. As we mentioned, this generally happens during another financing round. With a convertible note, then, you can secure financing from investors in the form of a loan now with the likelihood of conversion into equity contingent on future business valuation.

Convertible Note Terms

Since a convertible note is a loan from an investor, you’ll have certain terms just like you would with a traditional business loan. After all, investors interested in becoming noteholders are willing to accept the risks of financing a very early-stage startup—meaning that they expect the incentive that comes along with taking on that risk—and this is reflected in your terms. Here are four terms of convertible notes that are important to understand:

• Valuation cap: Generally just referred to as the “cap,” the valuation cap is the value at which the noteholder’s loan (both principal and interest, which accrues as paid-in-kind) converts into equity. Even if you raise your round at a higher valuation, you agree with your investor on a maximum cap. The lower the cap, the better the terms for your investor, since they’ll reap bigger increases in your company’s value the lower their buy-in begins.
  
• Discount rate: Convertible noteholders are generally offered an additional discount on their share price to honor their risk. Earlier investors generally see larger discounts (25% is standard for many very early investors).
• Maturity date: The maturity date, as we mentioned above, is the date on which the convertible note is due and you need to repay your investor for their loan.
• Interest rate: With convertible notes, an interest rate is not nearly as significant as it would be for a traditional loan. As a type of loan, however, the convertible note must carry interest. The interest rates on convertible notes are usually low, as investors are looking to receive equity in your company and not for you to actually have to pay the loan back in cash. When you do pay the convertible note back in equity, however, you’ll do so for both the principal and the interest that’s accrued.

What Happens If You Don’t Raise a Funding Round Before Your Maturity Date?

We mentioned this possibility briefly earlier, but let’s discuss it in greater detail. Although the goal is always to raise an equity round and repay your convertible note before the maturity date, sometimes things don’t always go to plan. In this case, you might face a few different scenarios:

• Your noteholder could extend your note. Your investor may decide to extend the maturity date on your convertible note and push you toward raising your Series A funding round. The investor might negotiate terms, increasing the discount or lowering the cap, but it may potentially be worth it if you can get your loan extended.

• Your noteholder can make you pay your loan. Once again, a convertible note is a loan, and if the maturity date arrives, your noteholder may ask you to pay in full, both principal and interest. However, if you can’t pay the loan, you’ll have to declare bankruptcy. Typically, this is not in the best interest of the investor—if the investor extends the note, on the other hand, they’re giving you the opportunity to raise a funding round and, therefore, making it more likely to receive a return on their investment.
• You can try to convert the note to equity with a new cap. Finally, if you can find a common ground that works for you and your investor both, you can decide to convert the note into equity at a different valuation than the one originally intended.

Who Should Use Convertible Notes for Funding?

Ultimately, convertible notes are designed specifically for early-stage startups in high-growth phases. To actually make use of a convertible note, your company should be in talks with potential investors at angel and seed rounds of funding. Therefore, by the time you hit your Series A funding round, you’ll have a valuation, and you won’t have to worry about your convertibles.

Plus, since these notes are debt before they convert into equity, in order for convertible notes to create any value for noteholders, your company needs to be quickly growing on the path to a priced round. Otherwise, you might be stuck paying back your debt with interest if your note reaches maturity and your investor doesn’t extend your note. Even worse, you could have to liquidate your company if you can’t pay off your debts.

Convertible notes are also ideal for early-stage startups who want to close funding fast. Because a convertible note is really just a loan, all you need is a promissory note to get the deal done—unlike a standard equity deal that requires a long, involved term sheet. Additionally, you can close different terms with multiple investors with convertible notes—something you can’t do once you price your round.

Pros and Cons of Convertible Notes

If you’re considering a convertible note for your startup, first weigh these advantages and disadvantages.

• Pros: The major benefits of using convertible notes as a method of funding are their simplicity, speed, and avoidance of the need for valuation With a simple contract, your startup receives the funding it needs and the valuation is able to be pushed out to a time that makes more sense for your business. Since this is essentially an IOU, your business also doesn’t have to worry about making regular payments along the way, so it doesn’t impact your day-to-day cash flow.
• Cons: The major downside of a convertible note is that you will eventually be giving up some control over your business. When the convertible note comes due, the investor will be granted equity in your business. If you’re not ready to split ownership of your business with outside parties, this is not the right financing option for you.

Convertible Note Alternatives

It’s important to reiterate that not every startup should be issuing convertible notes to swaths of investors. In fact, not every startup should be raising venture capital at all. When you’re considering whether or not to issue convertible notes, you’ll want to take a step back and make sure that you’re actually ready to raise capital. This being said, although news coverage seems to suggest that a large number of startups receive venture capital, the opposite is true—startup funding statistics show that only 0.05% of startups raise venture capital.

With this in mind, let’s take a look at some convertible note alternatives.

Business Grants

There is substantial funding available out there that doesn’t involve a convertible note—especially for female founders, veterans, and founders of color. Along with those available for your specific type of business, you should look at the myriad of small business grants available. There are hundreds of grants you can apply to—and they don’t require equity or valuation.

SBA Microloans

SBA microloans are ideal for startups because they don’t require some of the same stringent credit requirements or extensive time-in-business history that other SBA loans do. Plus, these loans are also great if your business is involved in social causes or if you’re a founder in an underrepresented group. With an SBA microloan, you can access up to $50,000 with some of the most competitive terms available. Plus, with an SBA microloan, you won’t have to give up equity and you’ll receive access to the U.S. Small Business Administration’s famous resource network.

SAFE

If you still feel that raising venture capital is the way to go for your startup, and you’re comfortable with equity financing, you have another alternative to a convertible note. Some founders aren’t comfortable with convertible notes because of the debt aspect—they just don’t like the idea of taking on a loan in very early stages of their company.

The SAFE (Simple Agreement for Future Equity) is meant to circumvent this issue. Created by Silicon Valley startup incubator Y Combinator, the YC SAFE is meant to be a very flexible, founder-friendly alternative to convertible notes with zero debt involved. The SAFE is similar to a convertible note in the sense that it’s a financing instrument with the potential to convert to equity in the future at an identified milestone (i.e. a funding round). The big differences between these two financing options, however, include no maturity date or interest with the SAFE—which means no repayment from your startup. SAFEs can also be done with or without a cap or discount.

As you might expect, a SAFE is significantly riskier for investors. Therefore, some venture capitalists simply won’t participate in SAFEs due to the high risk involved. Nevertheless, for extremely promising companies that are in high demand, this is a possible alternative.

KISS

Moreover, you might also consider seed-stage VC firm 500 Startups’ KISS documents. KISS (Keep It Simple Security) works very similarly to everything we’ve already discussed. These are meant to be very short, customizable documents that allow founders and investors to work out terms that are right for them.

There are KISS documents for both a debt agreement that’s closer to a convertible note, plus an equity-only agreement that’s closer to a SAFE. If you have a startup lawyer you trust, or you’re not quite satisfied by the setup of a convertible note or SAFE, you might want to take a look into these to see if you can create a more custom agreement that suits you.

The Bottom Line

At the end of the day, finding the right funding is one of the most important parts of business progression and growth, especially for startups. If you’re an early-stage startup with rapid growth potential, you might be considering your options for venture capital. Although not right for every startup, you do have the option to explore venture capital funding, including convertible notes, if you think they’ll be the best choice for your business.

On the other hand, if you want to look for alternative solutions, including those outside of venture capital, you’ll likewise find that you have a variety of options available to you—SBA loans, grants, and even bank loans or lines of credit. Ultimately, by exploring all of your financing options and thinking about how they may or may not affect your business, you’ll be able to narrow down your choices to find the best funding for you.

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