Convertible Notes 101: A Founder's Guide to Startup Funding
In my practice advising early-stage companies, I frequently start financing conversations with convertible notes. They let founders raise capital quickly while postponing the valuation debate until a later equity round. That efficiency is useful, but I also remind clients that the note’s rate and valuation cap will affect their eventual ownership stake. Our firm’s goal is to confirm that those terms support our clients’ growth plans and risk tolerance.
In this quick guide, we will break down the convertible note into simple, understandable terms. We'll explore what a convertible note is, its key components, the pros and cons, and when it makes the most sense for your startup.
What is a Convertible Note?
At its core, a convertible note is a form of short-term debt that converts into equity at a later date. Think of it as a loan you receive from an investor today. Instead of repaying that loan with cash, you repay it by giving the investor ownership (equity) in your company during a future, typically larger, funding round.
This structure is popular in pre-seed and seed-stage financing because it allows companies to raise capital without having to set a firm valuation for the business, which can be difficult when a company is still in its infancy.
Anatomy of a Convertible Note
Every convertible note is defined by a few key terms. Understanding these is crucial to structuring a deal that is fair for both you and your investors.
1. Valuation Cap
The valuation cap sets the maximum company valuation at which the investor’s money converts into equity. This is a crucial term for investors, as it protects them from being diluted if your company's valuation soars in the next funding round (the "priced round").
Example: An investor puts in $100,000 on a convertible note with a $5 million valuation cap. Your company later raises a Series A round at a $10 million valuation. Because of the cap, the early investor's note converts as if the company were only valued at $5 million, effectively giving them twice as many shares for their money as the new investors. Without a cap, their investment would convert at the $10 million valuation, significantly reducing their ownership percentage.
2. Discount Rate
The discount rate rewards early investors for taking a risk on your company before it was more established. It gives them a discount on the share price paid by the investors in the subsequent priced round.
Example: Let's say your note has a 20% discount rate. In your Series A round, new investors buy shares at $1.00 per share. Your convertible note holder's investment would convert at a price of $0.80 per share (1.00×(1−0.20)). This allows them to get more shares for their investment.
Note: Often, convertible notes include both a valuation cap and a discount rate. In such cases, the investor typically gets the benefit of whichever term provides them a lower share price (and thus more equity).
3. Interest Rate
Since a convertible note is technically a loan, it accrues interest. This interest is usually not paid in cash. Instead, the accrued interest is added to the principal investment amount and converted into equity along with the rest of the investment. A typical interest rate might be between 2% and 8% annually.
Example: An investor gives you $100,000. The note has a 5% annual interest rate. If the note converts exactly one year later, the total amount converting into equity would be $105,000 ($100,000 principal + $5,000 interest).
4. Maturity Date
The maturity date is the date on which the note becomes due if a conversion event (like a qualified financing round) has not occurred. This is typically 18 to 24 months after the note is issued. If you reach the maturity date without raising a priced round, one of two things usually happens:
The investors can demand repayment of the principal plus accrued interest; or
The note converts into equity at a pre-agreed valuation (often the valuation cap).
Pros and Cons of Using Convertible Notes
Pros:
Speed and Simplicity: They are generally faster and cheaper to document than a priced equity round, requiring less legal negotiation.
Postpones Valuation: You avoid the difficult (and sometimes contentious) process of pricing your company at a very early stage.
Cons:
Potential Dilution: A low valuation cap can result in you giving away more equity than anticipated.
Debt Risk: If you fail to raise a priced round by the maturity date, you could be on the hook to repay the loan, which can be a death sentence for a cash-strapped startup.
Stacking Notes: Managing multiple convertible notes with different caps and terms can complicate your capitalization table (cap table) for the next round.
Is a Convertible Note Right for You?
Convertible notes are most appropriate for pre-seed or seed-stage companies raising their first significant round of capital. They serve as a bridge to get you to your Series A, allowing you to hire key personnel, develop your product, and hit milestones that will justify a higher valuation in the future. Using them wisely can help ensure that your company has the funding it needs to continue to grow.