What is a convertible note?
A convertible note is currently a popular fundraising vehicle, with both investors and fundraising companies seeking to use it, but what exactly is it?
A convertible note is, simply put, a hybrid between receiving a loan and receiving an equity investment in your company. In essence, an investor loans money to a company and, rather than receiving that money (plus interest) back at the maturity date, the loan has an opportunity to convert into equity based on pre-determined metrics.
What are common characteristics of a convertible note?
Common metrics include:
- That the loan will convert automatically if the company raises an equity round (and because of this, convertible notes are sometimes referred to as “bridge rounds” since they bridge the gap for a company until the next equity offering);
- That the loan will receive a discount on equity if converted;
- That there are certain valuation floors or ceilings for the conversion (so that the company and investor know the range of valuations that the note might convert into);
- That the loan will convert into common equity or some other pre-determined preferred equity if the company does not raise equity financing prior to the maturity date;
- That the interest will convert into equity as well as the principal; and
- That the company or the investor will get to make the ultimate call as to whether the loan does in fact convert.
When is a convertible note right for you?
Reasons to use convertible notes (from both the company and investor perspective) include:
- To delay valuing the company early (because the company will want a higher valuation, and the investor will want a lower valuation, so that discussion is tabled for the length of the loan);
- To add additional protection for investor or to incentivize early investment in the life of a company—as a lender to the company the investors get preference in liquidation.
- To provide a small bridge of capital before a company focuses on a larger equity raise; and
- To test a company-investor dynamic before locking in the company-investor relationship for the indefinite future.
If, as the company, you are choosing between offering a convertible note and straight equity, spend some time figuring out what terms you could secure for a straight equity investment. Unless the note is structured so that the company gets to decide whether the loan converts or not, it’s true debt, and will need to be repaid if the investors don’t convert.
If you are weighing this same decision as the investor, remember that the equity will be the most lucrative part of the investment, not the interest (plus these are rarely secured debt), and focus your attention accordingly on the terms.
Regardless of what side you are on when negotiating these terms, it is important to remember a promissory note is a security and you will need to comply with a number of state and federal security laws.