A convertible note is a short-term debt instrument that can convert into equity under predefined conditions. It is commonly used in early-stage financing for startups. Investors provide funds to the company in the form of convertible notes, which are recorded as debt until a conversion event occurs. This event usually takes place during a future funding round or a significant event like an acquisition or IPO. Upon conversion, the notes transform into ownership stakes in the company, typically in the form of preferred shares. Convertible notes offer a hybrid structure, blending elements of both debt and equity.
The mechanics of a convertible note depend on whether a conversion event takes place. If no conversion occurs, the note functions as a traditional debt instrument, with a maturity date and potential interest earnings. In case of a conversion, the amount converted into equity includes the principal amount and any accrued interest. The conversion price can be determined by a valuation cap or a discount rate. A valuation cap sets the maximum value at which the notes convert, while a discount rate provides noteholders with a reduction on the valuation at the time of conversion. Some convertible notes may specify both a cap and a discount rate, with the conversion taking place at the lower of the two options.
Convertible notes offer benefits for both founders and investors. They allow for faster access to financing, simpler negotiations compared to priced equity rounds, and lower legal and administrative costs. Founders can postpone the valuation discussion until a later stage, while investors can negotiate favorable conversion terms and receive interest payments that can convert into equity. However, founders should consider potential dilution and the strain of interest payments on cash flow, while investors should be cautious about an overly complex capitalization table.