Convertible Notes: The Basics

For start-ups, raising capital is a continuing challenge. After you’ve tapped friends and family, one way to meet that challenge is with convertible notes.

A convertible note is a short-term debt that converts to equity at a pre-determined time, often when the start-up completes its first-round financing, bringing venture or external investors in for the first time. Instead of interest and a return of principal, the holder of a convertible note has the right to convert the note into shares of stock in the company.

Convertible notes are a popular financing vehicle for start-ups because the investors and the issuer can defer the valuation of the company until a point in time when operations have generated enough data on which to base a credible valuation of the company. Valuations necessarily involve some guess-work, but more data points over a longer period of time will generally be more persuasive to investors.

The key terms of a convertible note are:

The discount rate – Early investors bear substantially more risk than those that come in later. Holders of convertible notes receive a discount on the price at which their notes convert into equity

The valuation cap – A valuation cap sets the upper limit on the valuation of the issuer at the point that a convertible note converts into equity. The cap is another way to compensate early investors for their greater risk by reducing the price at which a note converts to equity.

A convertible note can incorporate a discount, a valuation cap or both. Or, the terms of the note may allow for conversion at the lower of the prices generated by the discount or the cap.

As with any investment in a start-up, convertible notes are not without significant risk to the investor. Even where the amount of capital to be raised and the number of investors in the notes do not require registration under federal or state securities laws, issuers must take care that disclosure to potential investors is accurate and comprehensive to avoid allegations of fraud or misrepresentation.

Contact me for a more detailed discussion of convertible notes.