Financing Your Company

How Do Convertible Notes Work?

July 31, 2019July 31, 2019
How Do Convertible Notes Work?

A convertible note—sometimes called a convertible debt or convertible bond—is a type of short-term financial instrument that new companies use to raise early-stage capital.  The convertible note is generally considered a “debt instrument” because the investment facilitated by the note will almost always accrue interest for the investor.  However, convertible notes might be better characterized as a “hybrid instrument”, considering they have both debt- and equity-related elements. 

In the simplest of terms, a convertible note is a debt that—at some predefined future time— converts to equity.  When an issuer and investor sign a convertible note, the investor loans a sum of money (with an agreed-upon interest rate) to the note issuer.  Instead of a return of principal investment plus interest, the investor will receive ownership in the form of company shares.  The investor is essentially “betting” that the company will be successful; should the company flourish, they will be rewarded with high-value shares in a growing business.  

From the note issuer’s perspective, the convertible note minimizes cash debt; instead of demanding the accrued interest be repaid in cash, investors can use the debt to purchase a greater amount of equity in the company.  If handled correctly, exchanging debt for shares can be advantageous for the company, as it essentially eliminates their debt burden.  However, the amount of equity must be carefully monitored to avoid the dilution of shares.  Likewise, anytime an investor converts their investment into equity, they are gaining ownership in the company at the expense of other shareholders, including the owner.

For business owners trying to raise capital, the other great advantage of the convertible note is that it negates the need for a company valuation, making them particularly attractive for businesses with high potential for short-term growth but little history or no credit.  For this reason, they’re heavily used by start-ups and generally popular throughout the Tech industry.

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Key Terms of a Convertible Note

By combining elements of debt and equity into one instrument, the convertible note aims to satisfy both issuers and investors.  However, this hybrid approach comes at a cost; convertible notes are notorious for being complex, lengthy, and difficult to negotiate.  For business owners and investors alike, a legal professional should be consulted before signing any sort of agreement.  Convertible notes can include a myriad of unfixed terms and conditions, making them generally unnavigable for individuals without a legal background.  Nonetheless, most convertible notes will include the following terms at a minimum:

Maturity Date

Every convertible note will include a maturity date, which is the point at which the note is “due”, meaning it must be either repaid or converted to equity.  Most notes will convert to equity automatically upon a triggering event, most frequently the start of a new funding round or the sale/merger of the company.  However, if these triggering events fail to occur, the maturity date is there to ensure the investor gets repaid.

Valuation Cap

The valuation cap is the maximum amount that an early-stage investor will pay for future equity.  Essentially, it is a reward for the early investors; as the company grows and gains value, its share price will increase as well.  Valuation caps basically “cap” the price of future shares, but only for the initial investors.  

Interest Rates

Convertible notes, by nature, are debt instruments and required to carry interest.  This interest will accrue in dollars and cents but can be converted to equity along with the principal investment.

Discount Rates

The discount rate gives early-investors a special discounted price for future shares.   Similar to the valuation cap, discount rates are awarded to preliminary investors for taking-on the added risk of investing at the early stages.  

Successfully negotiating these four terms is of the utmost importance for business owners, as these provisions will have massive consequences on the investment.  Mishandling negotiations can cost owners hundreds-of-thousands of dollars (often in the form of equity), and in the worst-case, dilute the shareholders.  

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Avoiding Ownership Dilution

Any time a company accepts new investments through a convertible note, they are consequently promising equity to a new individual and thus adding a new owner.  This must be carefully monitored by note issuers, as company ownership represents a zero-sum game; the more shares that the investors have, the less the issuer will have.  Adding new owners typically doesn’t result in transferring or selling shares, instead shares are “split”, increasing the number of shares but decreasing their overall values.  If owners aren’t careful, they can easily dilute the company shareholders, which includes themselves.

This is exactly where the written agreement must be carefully worded, well thought-out, and firmly negotiated.  The four terms listed above—maturity date, valuation cap, interest rates, and discount rates—can be powerful tools used to avoid ownership dilution.  A high valuation cap will reduce the risk for dilution, as it dissuades current shareholders from purchasing additional shares.  On the other hand, high discount rates and interest rates will entice owners to purchase more.  In general, owners should negotiate for low discount and interest rates, in-conjunction with a high valuation cap.  

Owners that carelessly take-on new investors may inadvertently dilute the shareholders’ ownership, putting their company and its owners at serious risk.  Since convertible notes can be lengthy and complicated contracts, a legal professional should be consulted before entering an agreement.

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