What is a convertible note?

A convertible note is a loan to a young company that is designed to be repaid in shares rather than in cash: when the company next sells shares at a negotiated price, the amount lent plus the interest it has earned converts into those shares, at a lower price than the new investors pay. Until that round happens, the note is debt, with a principal, an interest rate and a maturity date, and the company owes the money.

That double nature is the whole instrument. The investor lends today without anyone having to agree on what the company is worth, and the price question is settled later by the investors of the priced round, with a reward for having come in early. The note's few pages decide how large that reward is, what happens if the round never comes, and what the holder can do on the day the loan falls due.

Contract and securities law differ from one country to the next, and the terms described here are the ones commonly negotiated, not a legal standard. This article is general information, not legal, tax or investment advice. Its worked example is illustrative and its figures are computed, not market data.

How does a convertible note work, from signature to conversion?

A convertible note works in three moments: the investor wires the principal, interest accrues on paper while the company builds, and at the next priced round the principal and the accrued interest are exchanged for shares of that round at a reduced price. No cash normally returns to the investor along the way, and no shares exist for the holder until conversion.

At signature the investor sends the principal and receives a promise to pay, not a share certificate: the holder is not on the share register and usually has no vote. At the round, a new investor negotiates a price per share with the company. That is what "priced round" means: a sale of shares, usually preferred shares, at a stated price that implies a valuation. The note then converts automatically, provided the round is large enough to count under the note's definition, and the holder becomes a shareholder of the same class as the new investors or of a closely related class.

If no round comes before the maturity date, the note is simply a loan that has fallen due, and the paper decides what the holder may do about it.

What terms does a convertible note contain?

A convertible note contains eight terms that matter: principal, interest rate, maturity date and what happens on it, conversion discount, valuation cap, the qualified financing threshold, the treatment on a sale of the company, and the amendment rule. Each one moves value between the founders and the holder, and several interact.

The discount and the cap are the price terms. A discount says the holder pays, for instance, 80% of what the new investors pay. A cap says the holder converts as if the company were worth no more than a stated amount, however high the round's valuation turns out to be. A note may carry one, the other, both or neither, and when it carries both the usual wording gives the holder whichever produces the lower price per share.

The qualified financing threshold protects both sides from a trivial conversion. Without it, a small sale of shares to a friendly buyer at an arbitrary price could convert every note. With a threshold, only a round that raises a real amount of new money, defined in the note, converts the notes automatically.

The amendment clause is the term most often skipped and most often used. Notes issued as a series normally say that the holders of a majority of the outstanding principal, together with the company, may amend or waive any term for every holder. An extension of the maturity date is the standard case.

How does interest accrue on a convertible note, and how does it convert?

Interest on a convertible note accrues from the day the money is received, at the stated yearly rate, and is added to the amount that converts rather than paid in cash. The holder therefore receives shares for the principal and for the interest together, at the same conversion price.

Two details change the result. The first is whether interest is simple or compounding. Simple interest is charged on the principal only. On $400,000 at 6% a year, 15 months of simple interest comes to $30,000, so $430,000 converts. If the same note compounded yearly, the amount would be about $430,222, a difference of roughly $222 over that period, which grows with time and with the rate.

The second is the day count: a note may compute interest on the actual number of days over a 365-day year or on a 360-day year, and the note says which.

Interest is real dilution for the founders. In the example, $30,000 of interest becomes 30,000 shares at a conversion price of $1.00.

How is the conversion computed with a discount, a cap and the better of the two?

The conversion is computed by dividing the note's balance, principal plus accrued interest, by a conversion price, and the conversion price is the lowest of the prices the note allows: the round price less the discount, or the price implied by the valuation cap. The lower the price, the more shares the holder receives.

The worked example uses these assumptions. An investor lends $400,000 at 6% simple interest, with a maturity date 18 months after signature, a 20% discount and a $6,000,000 valuation cap. The company has 6,000,000 shares outstanding on a fully diluted basis, and the note measures the cap against that number. Fifteen months later, new investors put in $3,000,000 at a pre-money valuation of $9,000,000.

The holder's 430,000 shares are worth $645,000 at the round price of $1.50, against $400,000 lent. Put the other way, the same $430,000 would have bought only 286,667 shares at the round price, so the note delivered 50% more shares than a new investor gets for the same dollars. Here the cap gave an effective discount of one third, larger than the 20% written in the note.

One simplification deserves a flag. In this example the round price is computed on the 6,000,000 shares that existed before the notes converted. Many term sheets instead state that the pre-money valuation includes the shares issued to note holders, which lowers the round price and shifts the notes' dilution onto the existing shareholders rather than onto the new investors. The definition of "capitalization" in the note and in the round's term sheet decides this, and it is where conversion spreadsheets most often disagree.

When does the cap beat the discount?

The valuation cap beats the discount whenever the round's pre-money valuation is higher than the cap divided by one minus the discount. With a $6,000,000 cap and a 20% discount, that crossover sits at $7,500,000: below it the discount gives more shares, above it the cap does.

The chart below takes the same $430,000 balance and the same 6,000,000 shares, and changes only the valuation agreed at the round. One series shows a note with the 20% discount alone, the other the note of the example with both terms.

The shape explains why both sides argue about the cap rather than the discount. With a discount alone, a holder's share count keeps falling as the company's valuation rises: the early investor took the most risk and is diluted by the very success the money paid for. The cap puts a floor under the share count. For the founders, the cap is a ceiling on how much of a high valuation they keep for themselves, and a low cap in a strong round can hand note holders a far larger slice than the headline discount suggested.

What happens at maturity if no round has occurred?

At maturity without a qualified financing, a convertible note is a loan that is due: the company owes the principal and the accrued interest, and the note's wording sets what the holders can do. In the example, 18 months of simple interest brings the amount owed to $436,000.

Notes generally provide one of four outcomes, or a combination.

• Repayment on demand. The holders, often acting by majority, may require payment. A company that has not raised a round seldom has the cash, so this right is mostly leverage in a negotiation.
• Extension. The majority of holders and the company push the maturity date back, sometimes in exchange for a lower cap, a higher discount or a higher rate.
• Optional conversion. The holders may convert into existing shares, often ordinary shares, at a price fixed in the note, commonly derived from the cap or from a separate, lower valuation.
• Automatic conversion at maturity. Some notes convert without any decision, at a stated price, which removes the repayment risk for the company and the creditor position for the holder.

The realistic outcome in most cases is an extension, because forcing repayment from a company without cash tends to destroy the value of the claim. But the holder's rights at maturity are a creditor's rights. If the note is not paid, extended or converted, the company is in default, default interest may run, and the holder may pursue the debt under the law that governs the note, up to and including insolvency proceedings where that law allows.

What happens to the note if the company is sold before it converts?

If the company is sold before a priced round, a convertible note normally gives the holder the greater of two things: repayment, often at a multiple of the principal, or conversion into shares just before the sale so that the holder is paid as a shareholder. Without such a clause, the holder would receive only principal and interest however well the sale went.

Take the example note with a clause that offers either twice the principal or conversion at the cap price. The sale happens 12 months after signature, so interest is $24,000 and the balance is $424,000. Repayment at twice the principal is $800,000. Conversion at the cap price of $1.00 gives 424,000 shares.

If the buyer pays $2.00 per share, conversion is worth $848,000 and the holder converts. If the buyer pays $1.50 per share, conversion is worth $636,000 and the holder takes the $800,000 instead.

Three points need reading. Whether the multiple applies to principal alone or to principal and interest. Whether the choice belongs to each holder or to the majority. And where the payment ranks against other creditors and against any preferred shareholders, which the note and the sale agreement together determine.

Where does a convertible note sit as debt?

Until it converts, a convertible note is a liability of the company and the holder is a creditor, not a shareholder. The United States Securities and Exchange Commission draws the same line in its investor bulletin on SAFEs, published in 2017, where it describes convertible notes as debt that generally represents a current legal obligation by the company to the investor.

Ranking follows from that status and from the note's terms. In an insolvency, creditors are generally paid before shareholders, so a note holder stands ahead of the founders and of earlier equity investors. Most startup notes are unsecured, which places them behind any lender holding security over the company's assets, and many contain a subordination clause that expressly ranks them behind bank debt. Notes of the same series usually rank equally among themselves and share any partial payment in proportion to their principal.

On the balance sheet, in general terms, the note appears as a liability at the amount owed, and the interest accrues as an expense even though no cash leaves the company. Accounting standards may require more than that: conversion features, caps and repayment multiples can call for separate measurement or fair-value treatment, depending on the framework the company reports under and on the exact wording. On conversion, the liability disappears and equity increases by the same balance. The classification is a question for the company's accountant or auditor, and it matters beyond presentation, because outstanding debt can affect bank covenants, grant conditions and solvency tests.

The legal nature has another consequence. A note is ordinarily a security, and offering it to investors falls under the securities law of the place where it is offered, with the exemptions and investor qualifications that law provides.

Why do founders and investors choose a convertible note?

Founders and investors choose a convertible note because it lets money arrive before the company can be valued with any confidence, with less documentation than a share issue. The price is set later, by investors who have more information, and the early investor is paid for the wait through the discount, the cap and the interest.

For founders, the appeal is speed and timing. A note is a short document, it does not require a new class of shares, a shareholders' agreement or board changes, and several investors can sign identical notes weeks apart as funds become available.

For investors, the note offers three things a direct share purchase at that stage does not: a claim that ranks ahead of the shareholders, a date on which something must be decided, and a price that adjusts to the first serious valuation instead of being guessed at the start.

What are the risks for each side?

The risks of a convertible note are dilution that is hard to see in advance and a debt deadline for the company, and for the holder the possibility that the loan is never repaid, the round never comes, or the conversion gives less than expected. Both sets of risks come from the same terms read from opposite sides.

For the company and its founders:

• Hidden dilution. Nobody knows the share count the notes will produce until the round is priced. A low cap, accrued interest and several series can add up to far more dilution than the founders modelled.
• The maturity date. A debt falling due during a difficult fundraise weakens the company's hand with holders and with new investors alike.
• Pressure from new investors. A lead investor may ask note holders to accept changed terms as a condition of the round, which puts the founders between two groups.
• Solvency. A liability on the balance sheet counts in any test of whether the company can pay its debts.

For the holder:

• Loss of the whole amount. The SEC's bulletin on SAFEs in crowdfunding warns of the speculative risk of whether an early venture succeeds at all and of the illiquidity of a stake in a company not listed on an exchange; both apply to any early-stage instrument. A right to repayment is worth what the company can pay.
• No conversion on good terms. Without a cap, a very high round valuation leaves the holder with few shares. With a round below the threshold, the note may not convert at all.
• Amendment by the majority. Terms can change without the consent of a small holder.
• No shareholder rights before conversion. No vote, usually limited information rights, and no say in the terms of the round that will convert the note.

The SEC's investor education material on convertible securities, written chiefly about public companies, gives advice that carries over: understand the terms of the deal, and how the conversion formula works, including its effect on dilution. It distinguishes a fixed conversion formula, where the number of shares is predictable, from one based on a fluctuating price, where a lower price means more shares issued. A startup note sits in between: the formula is fixed, but one of its inputs, the round price, is unknown at signature.

How does a convertible note differ from a SAFE?

A convertible note is debt that converts, while a SAFE, a simple agreement for future equity, is a right to future shares with no loan behind it: no interest, no maturity date and no repayment claim in the ordinary course. The conversion mechanics, a discount, a cap or both, are otherwise close relatives.

The practical difference is the day nothing happens. A note holder reaches maturity with a claim and a seat in a negotiation. The SEC's bulletin points out that a SAFE, depending on its terms, may never be triggered, in which case it is not converted and the investor is left with nothing. In exchange, a company that issues SAFEs carries no debt deadline.

What should you check before signing a convertible note?

Before signing a convertible note, check that every term has a number or a rule attached and that you have computed the conversion yourself under at least three round valuations.

• Principal, and whether the note is part of a series with a stated maximum total.
• Interest rate, simple or compounding, the day count, and whether interest converts or may be paid in cash.
• Maturity date, and the exact rights on that date: demand, extension, optional or automatic conversion, at what price, decided by whom.
• Discount, and the share price it is applied to.
• Valuation cap, pre-money or post-money, and the definition of the share count used as divisor, including options, the option pool increase and other convertible instruments.
• Whether the holder gets the better of the discount and the cap, stated in so many words.
• The qualified financing threshold, and whether converting notes count toward it.
• The class of shares received on conversion and whether they carry the same rights as the new investors' shares.
• Treatment on a sale of the company: the multiple, its base, the conversion alternative and who chooses.
• Ranking: secured or unsecured, any subordination to other lenders, equal ranking within the series.
• Amendment and waiver: the majority required, and how much of the series the largest holder owns.
• Events of default and their consequences.
• Information rights before conversion, and any right to invest in later rounds.
• Transfer restrictions, governing law, and the securities law position of the offer.

When the round finally closes, the settlement itself is brief: no cash moves for the note, the company cancels the debt against the issue of shares, and the holder receives a conversion notice and a place on the updated share register. The cash of that day flows only from the new investors to the company. Everything that determines what the holder owns at that moment was fixed months or years earlier, in the terms listed above.