Convertible Note: What It Is, How it Works + Real-World Examples

Companies all over the world raise funding through both equity and debt. But what about debt that has the potential to convert to equity later down the line? Here we take a look at convertible loan notes and explore when they're most useful for scaling companies.

What is a convertible note?

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There is a whole lexicon of terms used where convertible notes are concerned. Investors concentrate on interest, maturity dates, valuation caps and discounts. Let's dig in to the different aspects of a convertible note agreement.

The key components of convertible notes

Valuation cap

Often, convertible notes will have valuation caps. Here, the cap is the maximum valuation at which the convertible note can convert into equity. This is designed to incentivize investors to get on board at an early stage in a company that's scaling quickly.

Here's how a valuation cap works: if you agree a fundraising at a valuation cap of £5 million, for instance, and the next funding round sees your company valued at £10 million, the valuation cap gives the convertible note holders a de facto discount of 50% compared to new shareholders coming in at the later round.The higher you raise beyond £10 million, the more attractive the discount becomes for the note holder.

Discount

Discounts are closely related to valuation caps. Many convertible notes will have both a valuation cap and a discount, but many convertible notes are agreed with a discount and no cap, so it's worth understanding how the discount on its own applies to future funding rounds.

The discount on a convertible note applies to the rate at which the convertible note holder can buy shares at a subsequent equity financing. Imagine a convertible note is issued at seed stage carrying a 20% discount on the company's shares at the next round. If at the next round the company's shares are worth €5, the convertible note would convert to equity at a price of €4 per share.

Interest

When they're originally issued as loans, convertible debt normally means interest payments. The interest rate can range from very minimal interest up to north of 10%. One helpful benchmark might be the UK government's Future Fund investment vehicle, which has standard terms of 8%.

Pre-money or post-money?

Convertible notes can be designed to convert pre-money or post-money. In the next funding round, the notes might be set up to convert before any new investor's stake is accounted for, meaning the value of the note is included in the pre-money valuation in financing discussions.

With a post-money conversion, notes convert after new investors' money is factored in to the round and present on the cap table. This means that post-money convertible note holders dilute the stakes of existing shareholders: it's always worth paying attention to the convertible note terms, as the pre- or post-money status can have a real impact on dilution in new funding rounds.

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Maturity date

Like many loans, convertible notes come with maturity dates. A maturity date is the date in the future by which the debt should be repaid, including interest (if applicable). Companies usually aim to convert the debt into equity before the loan is repaid.

Some convertible notes are issued with no maturity date, but it's common to see convertible notes maturing between 12 to 36 months in the future. If the company raises a new equity round before the debt is repaid, of course, the loan's terms are no longer valid.

Ways to handle a convertible note in a funding round

So if a convertible note turns into equity, how are the equity stakes of founders, employees, existing and new investors affected? The answer depends on which method you use to calculate the post-money valuation at the subsequent funding round. Let's quickly sum up two ways to do this.

Base the convertible discount on the pre-money valuation

Let's say the pre-money valuation in the new funding round is fixed at £20 million, the new investors put £4 million in to the business, and the convertible note issuer's agreed discount is 20%. To calculate the price per share, without a cap or discount, you'll take the pre-money valuation divided by the total number of pre-money shares. This includes existing shares issued by the company as well as options, as they will convert to shares later.

If there are 2 million pre-money shares, the price per share is £10. This means the convertible note would convert to equity at a price per share of £8. If the discount is based on the pre-money valuation,

Base the discount on the post-money valuation

Alternatively, you could choose to anchor your new funding round on the post-money valuation. This method is favourable for new investors, as their stake is not diluted by discounts given to earlier investors. This method tends to dilute founders more. 

What are the benefits of convertible notes for startups?

The terms are simple

Compared to an equity fundraising, the terms of a convertible note are relatively short and easy to interpret. This makes the financing process easier for the early-stage startups who typically take advantage of these notes. Many investors have created their own standardized versions of convertible notes, such as SAFEs (Simple Agreement for Future Equity) which are a popular method of convertible financing in the US.

They can help find a way around valuation disagreements

Startups tend to have a hard time properly valuing their company in the seed round – it's notoriously hard to accurately value enterprises that may not have proven revenue models, and where the team is still being built.

In early-stage equity rounds, although finance and accounting teams can map out funding projections and exit models using cap table and equity data, companies can easily find themselves in situations where there is misalignment between founders and investors on the value of the company.

Because they are designed to convert to equity in the future, convertible loans effectively postpone the valuation decision, which can suit both founders and investors. Startups get the money they need up front, and the valuation question can be settled at the next round when the company is a little more mature.

Unsecured notes mean you hold on to your assets if things don't go to plan

In early-stage technology companies, convertible notes are usually (but not always) unsecured, meaning the investor does not have a claim on any company assets if the loan is not paid back. With secured convertible notes, investors have rights over business assets if the note cannot be paid back.

The limitations of convertible notes

Valuation caps and discounts can undersell your company valuation

Even if you don't have to agree on a concrete valuation with a convertible note, founders often find themselves agreeing to valuation caps that will give the convertible note holder a significant discount on the next round of equity funding. If the discount rate is too big, other potential investors may even be put off by the prospective dilution (particularly if the convertible note is post-money).‍

Convertible notes tend to be smaller than equity financings

It's a general rule that when you're building a company, the more runway you have the better. Because convertible notes usually come from a single investor, rather than a set of institutions and individuals all putting money into a round, convertible notes normally mean raising less money, giving you a shorter runway.

Raising significant funds in an equity round might give you years of runway to build new products and find new routes to market: your planning and execution timeframe might be shorter with a convertible note.

Where should convertible notes sit on your cap table?

It's not always easy to figure out where a convertible note should sit on your cap table. Conventionally, your cap table includes all holders of equity, and debt is not included. But convertible notes sit between debt and equity, meaning that it's sensible to register

It's best to have convertible notes situated in your equity software ready to be incorporated into the cap table as and when the note converts into equity. This means more clarity for your financial modeling and for convertible note holders, who know where they stand relative to your shareholders.

(Interested in how a convertible note might affect a future financing round? You can model the impact of convertible notes on your cap table with Ledgy's financing calculator.)

^FAQs

1. Is a convertible note debt or equity?

Convertible notes are Schrödinger's investment: they are both debt instruments and equity stakes. Initially, convertible notes are issued as debt, and the agreement made between the company and the convertible note holder usually states that the note will convert into equity at the next funding round.

2. How do convertible notes work?

Convertible notes are issued as loans to early-stage companies, and they are designed to convert into equity at a subsequent funding round. The initial loan is normally designed with a maturity date, and interest is normally paid by the company.

The unique property of a convertible note is that it is designed to convert into equity when certain conditions are met or when the company subsequently raises a new round of equity financing. The equity investment usually comes at a discount to the company valuation as determined at the next equity fundraising.

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