Convertible Notes 101: A Guide for Founders from a Silicon Valley Veteran

Convertible Notes 101: A Guide for Founders from a Silicon Valley Veteran

Founders often seek funding through various mechanisms to fuel their early growth. One popular option that has gained significant traction in recent years is the convertible note. As a founder, understanding how convertible notes work and their potential advantages and disadvantages is crucial when raising capital.

In this comprehensive guide, we will walk you through the ins and outs of convertible notes, exploring their definition, mechanics, common terms, strategies for setting terms, and much more. So let’s dive in and demystify the world of convertible notes!

What is a Convertible Note?

Before we get under the hood, let’s start by understanding what exactly a convertible note is. A convertible note is a type of debt instrument that startups often issue to investors during their early stages of fundraising. Unlike traditional loans, convertible notes are designed to “convert” into equity at a later stage, typically during a future financing round. Essentially, when an investor invests in a startup through a convertible note, they are effectively lending money to the company with the expectation of converting that debt into shares of the company’s stock at a pre-determined valuation.

Now, let’s explore the concept of convertible notes in more detail. When a startup is in its early stages, it may not have a clear valuation or a solid financial track record. This makes it difficult for investors to determine the value of the company and negotiate a fair equity stake. Convertible notes provide a solution to this problem by deferring the valuation until a later financing round when the company’s value is expected to be more established.

One of the key features of convertible notes is the conversion discount. This is a mechanism that rewards early investors for taking on the risk of investing in a startup at its early stage. The conversion discount allows the investor to convert their debt into equity at a lower price per share compared to the price paid by future investors in the subsequent financing round.

This discount acts as an incentive for investors to provide early-stage funding, as they have the potential to acquire a larger ownership stake in the company when the conversion takes place.

Another important aspect of convertible notes is the interest rate. Unlike traditional loans, convertible notes typically do not have a fixed interest rate. Instead, they may have a “cap” on the interest that can accrue during the term of the note. This cap ensures that the interest does not become a burden for the startup, especially if it takes longer than expected to raise additional funding. The interest rate and the cap are negotiated between the startup and the investor, taking into consideration the risk and potential return of the investment.

Convertible notes also have a maturity date, which is the date by which the note must either be converted into equity or repaid by the startup. The maturity date provides a timeline for the conversion or repayment, ensuring that the investor’s capital is not tied up indefinitely. If the startup fails to raise additional funding or reach a liquidity event by the maturity date, the investor may have the right to demand repayment of the principal amount plus any accrued interest.

Convertible notes are a flexible and popular financing instrument for startups in their early stages. They provide a way for startups to raise capital without having to determine a valuation upfront, and they offer investors the potential for significant returns if the startup succeeds. However, it is important for both startups and investors to carefully consider the terms and conditions of the convertible note, including the conversion discount, interest rate, and maturity date, to ensure a fair and mutually beneficial agreement.

How Does a Convertible Note Work?

Now that we have a basic understanding of what a convertible note is, let’s take a closer look at how it works. When a founder raises capital through a convertible note, the key element is the “conversion trigger.” Typically, this trigger is the occurrence of a subsequent financing round, known as a qualified financing event. Once this financing round takes place, the convertible note automatically converts into equity, giving the investor a predetermined share of ownership in the company.

Convertible notes also come with a maturity date, which is the point at which the note has to be either repaid or converted. If the startup fails to secure a qualified financing round before the maturity date, the investor has the option to demand repayment of the principal, along with any accrued interest.

What are the Common Terms of Convertible Note?

When issuing a convertible note, founders and investors need to agree on certain terms that govern the conversion process. Here are some common terms you should be aware of:

  • Conversion Discount: A conversion discount allows the convertible note holder to convert their debt into equity at a lower price per share compared to the price offered in the subsequent financing round. This discount serves as a reward for investing early and taking on higher risk.
  • Valuation Cap: A valuation cap sets a maximum valuation at which the convertible note converts into equity, regardless of the valuation in the subsequent financing round. This cap protects the investor from excessive dilution and ensures a fair share of ownership.
  • Interest Rate: Convertible notes typically accrue interest over time. The interest rate determines how much interest is added to the principal amount and affects the final conversion value.
  • Automatic Conversion Threshold or Event: Some convertible notes include specific qualification criteria that the subsequent financing round must meet for the conversion to take place. These criteria may include minimum investment amounts or the participation of specific investors.
  • Addressing Maturity or Sale: Defining the approach for scenarios like note maturity or pre-conversion exit events is crucial. These terms should be clear to avoid misunderstandings and ensure smooth financial management. Options typically include cash repayment, which is direct but could affect the startup’s liquidity, or conversion into existing stock, aligning with the company’s equity structure. In cases of an exit event, such as a company sale or merger before note conversion, agreements might include a premium repayment to the investor, recognizing their early-stage risk. 

Strategies for Setting Convertible Note Terms

Choosing the right terms for your convertible note is crucial to strike a balance that attracts investors while protecting the interests of the startup and existing shareholders. Here are a few strategies to consider:

  • Research Comparable Deals: Analyze similar convertible note deals in your industry and geographical location to gain insights into prevailing market terms.
  • Balance Investor and Founder Interests: Strike a fair compromise that incentivizes investors while preserving the founder’s ownership and future financing options.
  • Consult with Legal and Financial Advisors: Seek professional guidance to navigate the complexities of structuring convertible note terms and understand the legal and financial implications.
  • Create a Win-Win Scenario: Craft terms that align the interests of founders and investors, fostering trust, and setting a strong foundation for future collaboration.

What Happens if a Convertible Note Matures?

Convertible notes have a specified maturity date, and it is essential to understand the implications of reaching this date without a qualified financing round. When a note matures, two possible outcomes can occur:

  • Conversion: If the startup successfully raises a qualified financing round before the maturity date, the convertible note automatically converts into equity as agreed upon, and the maturity date becomes irrelevant.
  • Repayment: If the startup fails to secure a qualified financing round before the maturity date, the investor can demand repayment of the principal amount, along with any accrued interest. Repayment can be made in cash or sometimes in common equity.

Can a Convertible Note be Paid Back?

While convertible notes are primarily designed to convert into equity, there are instances when a startup may have the option to repay the note in cash. This scenario typically arises when the startup has sufficient cash resources to meet its financial obligations and chooses not to proceed with the equity conversion.

However, paying back a convertible note instead of converting it into equity may lead to certain consequences, such as dilution concerns among existing shareholders, potential tension between founders and investors, and missed growth opportunities for the startup.

Why Do Startups Use Convertible Notes?

Convertible notes offer several advantages that make them an attractive financing option for startups:

  • Flexibility: Convertible notes provide flexibility in terms of valuation. Since the conversion price is tied to a later funding round, founders can postpone the valuation negotiation process and focus on executing their business strategy.
  • Speed and Cost-Efficiency: Compared to a priced equity round, issuing convertible notes involves less paperwork, legal complexity, and transaction costs. This makes convertible notes a quicker and more cost-effective way to raise capital.
  • Less Dilution: By raising funds through convertible notes instead of selling equity upfront, founders can delay the dilution of their ownership stake and maintain a higher degree of control over their company.
  • Signal of Investor Interest: Attracting reputable investors who are willing to invest through convertible notes can serve as a positive signal to the market, validating the startup’s potential and attracting subsequent funding from other investors.

Key Considerations When Using Convertible Notes

While convertible notes offer numerous benefits, founders should carefully consider the following aspects:

  • Conversion Timing: Determine the most appropriate trigger for conversion, balancing the need to secure funding with the desire to reach key business milestones that may impact valuation.
  • Investor Relations: Maintain open lines of communication with convertible note holders and keep them informed of key developments and progress towards a qualified financing round.
  • Future Financing Planning: Anticipate the impact of a convertible note conversion on future financing rounds and ensure it aligns with the startup’s long-term growth strategy.
  • Negotiation and Documentation: Thoroughly review and negotiate the terms of the convertible note with the help of legal and financial professionals to safeguard the interests of the startup and its stakeholders.

Convertible Notes and Taxes

When startups utilize convertible notes, understanding their tax implications is crucial. Convertible notes, being debt instruments, initially do not equate to equity in the company. From a tax perspective, this means they are treated differently compared to issuing shares. For the startup, the money received through a convertible note is not considered income; therefore, it does not incur immediate tax liabilities. This is beneficial for early-stage startups that are often cash-strapped and looking to minimize upfront expenses.

However, the interest accruing on these notes can have tax implications. Even if not paid in cash, the accrued interest is often recognized as an expense for the startup and a potential income for the investor. This accrued interest can be deductible for the startup, reducing its taxable income, which is a significant advantage in the early stages of business development.

When the note converts into equity, the tax scenario changes. The conversion itself is typically not a taxable event for the startup or the investor. But post-conversion, investors may face capital gains tax on the eventual sale of the equity, depending on its value increase from the initial investment. Startups, therefore, must be mindful of these tax aspects when structuring convertible notes to ensure compliance and optimize financial outcomes.

Naturally, it is crucial to consult with tax professionals to ensure compliance and optimize the tax treatment of convertible notes.

The Pros and Cons of Convertible Notes

Now that we have explored the mechanics and considerations of convertible notes, let’s summarize the key advantages and disadvantages:

Pros:

  • Flexibility in valuation
  • Speed and cost-efficiency
  • Less dilution for founders
  • Signal of investor interest

Cons:

  • Potential dilution concerns for existing shareholders
  • Risk of tension between founders and investors
  • Missed growth opportunities
  • Tax complexities

Convertible notes vs. SAFEs: Which is better?

As you navigate the fundraising landscape, you may come across alternative financing instruments like Simple Agreement for Future Equity (SAFE). While both convertible notes and SAFEs serve a similar purpose, there are notable differences between them. Deciding which is better depends on the specific needs and circumstances of your startup. To make an informed decision, please check out our detailed guide on SAFEs here.

Now that you have a solid understanding of convertible notes, their mechanics, and their pros and cons, you are well-equipped to make informed decisions when raising capital for your startup. Remember, each fundraising scenario is unique, and seeking professional advice from legal and financial experts is crucial to navigate the complexities of convertible notes successfully. With this knowledge in hand, go forth and secure the funding you need to turn your startup vision into reality!

How can Eton help?

At Eton Venture Services, we pride ourselves on delivering professional, comprehensive valuation and financial advisory services tailored to your unique needs. Don’t settle for generic software models or inexperienced teams when it comes to critical financial valuations for your business. Trust Eton’s expert team to provide thorough, data-driven assessments that empower you to make well-informed decisions and optimize your outcome. Join the industry leaders who have already benefited from Eton’s exceptional client service and advisory expertise. Let us guide you through the intricacies of startup incentive equity and vesting. Get in touch with Eton Venture Services today.

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President & CEO

Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.

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