Guide to Convertible Notes

The convertible note provides investors with a means of investing in startups that are not yet valued. These short-term loans are converted into equity by the issuing firm. Investors loan money and are repaid with equity instead of capital & interest. The notes automatically convert into equity after reaching a milestone, typically when the company is officially valued for future purchases.

Convertible notes have become a widely used asset for early-stage venture funding. According to the 2020 Angel Funders Report, 65% of angel investments are conducted using convertible notes. The prevalence of such tools underscores the importance for startup investors and founders to understand this process.

While reading the details is unfortunately mandatory to understand this financial fun, it’s much easier if you have an actual Excel tool to play with and see the actual math. Fortunately, I’ve created the best calculator available, and it’s free. You can download it here: Convertible note calculator.

If you are a pro and want a cap table that can do the math for you, better than your lawyers, you can purchase a premium model here, which includes the convertible math: Pro cap table model.

What is a convertible note?

Convertible notes are short-term loans that convert to equity. Holders are essentially compensated with discount equity shares instead of regular payments. They are commonly used in early-stage companies when closing the initial funding round and in later stages when seeking money for a ‘bridge round’ before their next planned raise.

When a startup issues a convertible note, it is borrowing money from the investor, with the understanding that the investor will have the option to convert the note into equity at a later date. The terms of the convertible note, including the interest rate, conversion price, and expiration date, are negotiated between the startup and the investor.

Who issues a convertible note?

There are two parties in a convertible note:

• Startups: Seeking funding, they issue convertible notes to investors.
• Investors: Looking to invest in the startup, they sign the note and hand over money.

Using a lawyer to facilitate this is generally advisable. Doing it yourself can lead to mistakes in critical areas.

Why are convertible notes used by startups?

Convertible debts have clear advantages, speeding up the transaction process. By compensating your first investors, you acknowledge the risks they take on as early supporters.

Flexibility

First, convertible notes offer flexibility in setting the terms and conditions of the loan. Unlike traditional debt instruments, which have fixed terms and interest rates, convertible notes allow the startup and the investor to negotiate the terms of the loan, including the interest rate, conversion price, and expiration date. This can make it easier for the startup to raise capital on terms that are favorable to both parties.

Speed

Second, convertible notes are quick and easy to issue. Unlike equity financing, which can involve complex legal and regulatory processes, convertible notes can be issued relatively quickly and easily. This can be particularly useful for startups that need to raise capital quickly.

Delayed

Third, convertible notes can be converted into equity at a later date. This allows the investor to participate in the potential growth of the company without having to immediately purchase shares of stock. If the company’s stock price increases in the future, the investor can convert the note into equity at a discounted price, potentially realizing a profit.

Who would typically use a convertible note when funding their business?

Convertible notes are used in the big and fancy world of high finance, but for our purposes, they are very common in startup land.

Let’s break things down by category:

• Geography: Convertibles are very well understood in North America and Europe. They are used to varying extents across the rest of the world too. Variants of convertible notes such as SAFE have very varying levels of comprehension
• Stage: For an angel and pre-seed (and smaller Seed rounds) it is almost expected that startups use convertibles. Once you start raising “series” rounds, you do a priced round
• When things aren’t going well: If you haven’t quite achieved what you need to between series rounds, startups can do a bridge round of funding (which investors don’t really like) and the mechanic is a convertible note
• Sector: Applies to all sectors, including SaaS, e-commerce, and marketplaces.

Simply put, convertible notes are the norm for early rounds.

What companies are good candidates for convertible notes?

Early-stage startups with rapid growth are prime for seed financing via convertible notes. There’s an expectation of raising additional funds within 12-18 months, often the maturity date of the note.

If investors believe the startup doesn’t intend raising additional funding then there is zero chance the deal will be structured as such.

The key is to have clear paths to valuation to ensure a conversion will not be problematic once the company has received a second round of financing.

How do convertible notes work?

Convertible notes are actually really simple to understand at the start. They can get really complicated though, mainly because they can make a lot of mess. I’m going to explain the mechanics of convertible debt as simply as possible and remove all the complicated bits.

1. You want money: You find an investor willing to invest in your fundraise through a note
2. You negotiate the terms of the note: You and the investors agree on the key terms of the note (which is mainly a discount rate and a cap)
3. A lawyer makes a note for you: You pay a couple hundred and the lawyer spits out a template for you. Don’t use a free template
4. Investors sign the note: You sign the note so it is legal
5. Investors wire you money: Investors give you the money
6. You get back to work: You do startup stuff for a year
7. You raise more money: Time to raise again. You find investors to do an equity round, and you agree on terms for the ‘qualifying financing round’ in which the note converts from debt into shares
8. The note turns into shares: The note holders get shares or equity in the company (often at the same terms of the new investors), joining your cap table
9. The note disappears: The note is dead now, you can burn it.

Some of these steps involve a crap tonne of work (such as finding investors) and some are a lot more complicated (such as how the note converts to equity).

What is a convertible note example?

The tricksy thing about convertible notes is that you have no idea how much your convertible note holders will own in your company until you know the terms of the new round.

The factors that affect the amount noteholders will receive will depend on:

• The discount rate
• The cap
• The interest rate
• The method of conversion
• The valuation of the deal

I can show you some mathematical examples but you’re going to stare at numbers and be bored and/or lost. The best thing to do is actually get an Excel model, fill in numbers and learn what happens by fiddling with assumptions. I made a free Convertible note calculator so you can do that.

What are the key terms of a convertible note?

The key terms of a convertible note typically include a cap, discount, and interest rate. There are other terms you need to be aware of that I’ll fill you in on too.

• Cap: Maximum pre-money valuation for equity conversion.
  • The cap is the maximum pre-money valuation at which the loan will convert into equity. The cap helps protect the investor by ensuring that their investment will convert into equity at a valuation that is favorable to them. For example, if the company is valued at $10m but the valuation cap is $1m, a $100k investment would result in a 10% share of the company instead of a 1% share.
• Discount: Reduced price for equity conversion
  • The discount is the percentage of the subsequent equity round’s price that the investor will pay for the loan’s conversion. The discount helps incentivize the investor to make the loan since they will pay a lower price than other investors in the subsequent equity round. If the discount is 20% and shares are sold for $1 per share during a later investing round, the investor’s stock will be priced at 80 cents per share.
• Interest Rate: Return rate on the loan, typically at the statutory minimum.
  • The interest rate is the rate of return that the investor will receive on their loan. This rate is usually lower than the rates charged by traditional lenders since the investor is taking on additional risk by making a loan to a startup. Because your note is debt, it needs to have an interest rate which is normally set at the statutory minimum
• Principal amount: Total borrowed amount.
  • The amount of money that the startup is borrowing on the note or raising in the round of funding
• Maturity date: Deadline for repayment or equity conversion
  • The date at which the loan must be repaid or converted into equity. This is normally 12 or 18 months
• Conversion trigger event: Milestone initiating the conversion.
  • The event or milestone that triggers the conversion of the loan into equity.
• Qualified financing round: A legally defined round that triggers conversion.
  • This is a legal term just being aware of, since your note will only convert if some legalese says the round qualifies (normally it is a threshold for the amount raised such as $1m)

Benefits of convertible notes

It used to be the case that doing a convertible note at an early stage was a no-brainer and the advantages were clear. In the ‘olden days’, legal costs were a lot more than they are now. Doing a priced round could be really expensive, so you did a convertible round to save time and money.

With series-seed documents, Saas (in general), competition with lawyers yada yads, basically the price of getting deals done has come down a lot so the convertible vs equity discussion is a little less clear.

In general, doing convertibles still makes sense.

Simpler than an equity round

Convertible note financing documents are far simpler to document from a legal perspective. For the most part, they are just templates that lawyers just fill in a few numbers and names. The documents are short as all the niggly details are kicked down the road to be dealt with later when the real equity round happens.

Faster to complete

You can basically make and then sign a convertible note document and have a deal done in a few minutes (in theory). SAFE notes were designed to be done quickly.

Cheaper than equity funding rounds

In a venture capital priced round, not only are the financing documents far longer, but corporate documents need to be updated such as certificates of incorporation, operating agreements, shareholder agreements, voting agreements, etc. Clearly, this takes more time and so ups the expense of hiring lawyers to complete the round.

Delay pricing discussion

Convertible notes allow startups to delay valuing their company, which is attractive to early-stage startups that have not yet demonstrated much progress in terms of product development or revenue. In exchange for giving investors a discounted price on future equity, startups are able to push the valuation decision to a later date. This is why many institutional seed investors, such as 500 Startups, exclusively use convertible notes for their accelerator investments.

You can get a better deal

I hate writing stuff like this as investors deserve to be respected for betting on you, but anyway.

If you deal with your friends, family, and fool (non-sophisticated) investors, they may not know better about how notes work. You can take advantage of them rather than deal with people who won’t be as generous.

Disadvantages of convertible notes

Although convertible notes have numerous advantages, they also have significant drawbacks for startup owners and investors.

Some investors don’t like to invest in convertible notes

On balance, given most of the founders of the term get, I as an investor would not do a CN. I just don’t think the juice is worth the squeeze.

A very famous investor emailed my friend (I was advising on the deal) “I do not do convertible notes because I don’t know how much I will own”.

They get complicated when it comes to converting them

I’ve taught you that CNs are simpler to do, but boy oh boy, can they fu** things up. I had a founder email me to say he took over as CEO of a startup and he just couldn’t understand the cap table. There were over a dozen convertible notes and he had no idea how they would convert. I mean he tried, but the legal docs were not written well so he didn’t understand the terms. The prior CEO had issues raising because it looked too messy to investors.

I’m telling you to be careful if you do notes. The math gets complicated and lawyers aren’t known for math skills.

Notes only work up to a certain value

I like a post that Jason Lemkin wrote a while back on Quora about this topic:

And with convertible notes, investors really have no idea exactly what they are buying. They just have a rough sense of the price and no idea at all of the terms. If the sums are small, that again simplifies your life.

So… If it’s a small check, and/or a check where the precise terms and price don’t really matter that much — notes and SAFEs are great. That’s why they work so well for smaller rounds at YC, etc.

But once the check sizes get larger, investors care about terms and precise prices. So what?

Well, the only “so what” is that will add stress to the transaction. You want to just get it closed. This is sales, folks. Sales of stock. So once the terms are fair — close the deal. 🙂 And as check sizes cross $1m, almost any investor won’t want to do debt or SAFEs.

After $1m or so, you can push them. They may still do it. But it will add stress to the transaction. Stress = risk.

Can be harder to raise future rounds

Convertible notes can be perceived as options, with the opportunity to allocate more in the future. When you aren’t on the investors’ cap table, they don’t really think of you as a core investment though.

Investors might not care about you as much

When you do a convertible, if no one is doing most or all of the deal, no one is the lead investor and they won’t feel committed to you. If you are in a position to get fancy names as investors and they put in small amounts, you don’t really matter to them in the scheme of things.

You need to keep raising

Convertible debt is an IOU with conditions. You sort of have to raise at least once more and can’t change your mind. Many convertible notes can include provisions for an automatic conversion on maturity, but many do not. But so what, investors invest to get a return and if you decide to run a lifestyle business, what now?

Sure, investors can ask to be repaid, but you blew the cash already?

I know Buffer and SlideBean are two examples of startups that changed direction.

Alternatives to convertible notes

Convertible notes are great because they can give you a lot of flexibility if you know what you are doing. Even if you don’t know what you are doing, using a template can help you just get your deal done. CNs are my personal preference. Don’t want to do a CN, well there are other options. But there are some downsides.

I tell you what the other options are and have blogs to explain them (at least for SAFE notes).

SAFE

YC created SAFE notes. These are convertible notes but are special because they aren’t debt, which removes issues including maturity dates and interest rates.

These documents are designed to be literally downloaded from the site, filled in and you are done. These documents have evolved from pre-money notes to post-money notes, and well, they involve some reading.

KISS

500 Startups created the KISS note, with similar goals to the SAFE notes. They just aren’t worth bothering to look into as I literally have never heard anyone mention them.

KISS notes are a bit different from the pre-money SAFE, but more similar to the post-money SAFE as they are more investor-friendly, offering more protections where the company fails.

My personal recommendation if you don’t want to read a lot is just to do a convertible note with standard terms. This can become a huge rabbit hole to go down which you don’t want to!

Conclusion

If you are doing an angel to smallish seed, then a convertible note is for you. Spend a few hundred bucks getting a friendly VC lawyer to help you. Learn about discounts (20%) and caps ($10m), get the interest rate as small as possible (ask a lawyer), and set the maturity date as long as you can.

If you know nothing about notes, I recommend spending a few hours reading so you know. Get my free convertible note calculator so you can see the consequences. Then hire a lawyer, find the investors, and get your round done.

Questions and answers

What is convertible debt in simple terms?

Convertible debt is a type of loan that can be turned into company stock at a later date. When a company takes out convertible debt, it is borrowing money from an investor, with the understanding that the investor will have the option to convert the debt into stock at a later date. This allows the investor to participate in the potential growth of the company without having to immediately purchase shares of stock.

For example, let’s say that a startup is looking to raise money but is not yet ready to issue equity. The startup could issue a convertible debt to an investor, borrowing money with the understanding that the investor will have the option to convert the debt into equity at a later date. If the company’s stock price increases in the future, the investor can convert the debt into equity at a discounted price, potentially realizing a profit.

What is a convertible note in investing?

Early-stage companies raise money with a convertible note because they have a high chance of failing, knowing this, investors hand over money as a bet hoping they will make more money in future.

Is convertible note equity or debt?

It is a hybrid.

Although a convertible note is initially considered to be a debt instrument, it can be converted into equity at a later date. This means that it has characteristics of both debt and equity, depending on whether it is being considered in its initial form or in its converted form.

What is a convertible debt agreement?

A convertible debt agreement is a legal contract between a startup and an investor that outlines the terms of a convertible debt instrument. A convertible debt agreement typically includes the interest rate, conversion price, and expiration date of the convertible debt, as well as any other terms and conditions that have been negotiated between the startup and the investor.

The convertible debt agreement serves as a binding legal contract between the parties, outlining the terms of the loan and the investor’s rights to convert the debt into equity at a later date. It also specifies the rights and obligations of both the startup and the investor, including the interest rate that the startup must pay on the borrowed money and the conditions under which the investor can convert the debt into equity.

What is a convertible note vs equity?

Equity means your investors have shares in a company.

A convertible note is a form of short-term debt that converts into equity when your startup raises again. Unlike direct equity investment, where investors buy shares upfront (equity), a convertible note starts as a loan, with the option to convert to equity later, often at a discount. This method delays the valuation process, offering flexibility for startups and potential cost benefits for investors.

Is convertible debt the same as a convertible note?

Convertible debt and convertible notes are similar, but they are not the same. Convertible debt and convertible notes are both types of debt instruments that can be converted into equity at a later date. However, they have some key differences.

Convertible debt is a loan that is issued by a company and can be converted into equity at a later date. When a company issues convertible debt, it is borrowing money from the investor, with the understanding that the investor will have the option to convert the debt into equity at a later date.

Convertible notes, on the other hand, are a type of debt instrument that is issued by the investor, rather than the company. When an investor issues a convertible note, they are lending money to the company, with the understanding that the company will have the option to convert the note into equity at a later date.

Is a convertible note considered an investment?

A convertible note is considered an investment because it represents an investment of capital by the investor in the company. When an investor issues a convertible note, they are lending money to the company with the expectation of a potential return on their investment.

What is the purpose of a convertible note?

The purpose of a convertible note is to provide a flexible form of financing for startups. Convertible notes are often used by startups as a form of bridge financing, allowing the company to raise capital without immediately issuing equity.

Are convertible notes good for startups?

Convertible notes can be a good form of financing for startups in certain circumstances. Convertible notes offer several benefits for startups, including flexibility in setting terms, quick and easy issuance, and the ability to convert the note into equity at a later date.

What happens to convertible note if the startup fails?

If a startup that has issued convertible notes fails, the outcome will depend on the specific terms of the convertible notes and the circumstances of the failure. In general, there are three potential outcomes for convertible notes in the event of a startup failure:

1. The convertible notes may be written off as a loss by the investors. If the startup fails and is unable to pay back the borrowed money, the investors may have to write off the convertible notes as a loss. In this case, the investors will not be able to recover any of the money they lent to the startup.
2. The convertible notes may be converted into equity in the company. Some convertible notes may have provisions that allow the investors to convert the notes into equity in the company, even if the company is failing. In this case, the investors may be able to convert the notes into equity in the company at a discounted price, potentially realizing a profit if the company is eventually able to turn things around.
3. The convertible notes may be converted into equity in a new company. If the startup is acquired by another company or is restructured in some way, the convertible notes may be converted into equity in the new company. In this case, the investors may be able to recover some or all of their investment, depending on the terms of the convertible notes and the circumstances of the acquisition or restructuring.

What are the three main parts of a convertible note?

The three main parts of a convertible note are the interest rate, the conversion price, and the expiration date.

1. The interest rate is the amount of interest that the startup must pay on the borrowed money. The interest rate is typically negotiated between the startup and the investor and may be fixed or variable depending on the terms of the convertible note.
2. The conversion price is the price at which the investor can convert the convertible note into equity in the company. The conversion price is typically set at a discount to the company’s future equity price, allowing the investor to participate in the potential growth of the company at a reduced cost.
3. The expiration date is the date on which the convertible note will mature and can no longer be converted into equity. The expiration date is typically set by the startup and the investor and may be based on the company’s expected timeline for raising additional capital or achieving certain milestones.

Are convertible notes a good investment?

Convertible notes can be a good investment for certain investors in certain circumstances. Convertible notes offer the potential for a high return on investment if the company’s stock price increases in the future, as the investor can convert the note into equity at a discounted price.

However, there are also risks associated with investing in convertible notes. If the company’s stock price does not increase or the company fails, the investor may not be able to recover the full amount of their investment. Additionally, the terms of the convertible note, including the interest rate, conversion price, and expiration date, can have a significant impact on the potential return on investment.

How does a convertible note work for an investor?

When an investor invests in a convertible note, they are lending money to the company with the understanding that the company will have the option to convert the note into equity at a later date. The terms of the convertible note, including the interest rate, conversion price, and expiration date, are negotiated between the startup and the investor.

At the end of the term of the convertible note, the investor has the option to convert the note into equity, typically at a discounted price. If the company’s stock price has increased in the meantime, the investor can convert the note into equity at a discounted price, potentially realizing a profit.

If the company’s stock price has not increased or the company fails, the investor may not be able to recover the full amount of their investment. Additionally, the terms of the convertible note, including the interest rate and the conversion price, can have a significant impact on the potential return on investment.

Do you have to pay back a convertible note?

Whether a startup has to pay back a convertible note will depend on the specific terms of the convertible note and the circumstances of the company. In general, there are two potential outcomes for a convertible note:

1. The convertible note may be paid back in cash. If the startup is successful and generates enough cash flow, it may choose to pay back the convertible note in cash at the end of the term of the note. In this case, the investors will be paid back the full amount of the borrowed money, plus any interest that has accumulated.
2. The convertible note may be converted into equity in the company. Some convertible notes may have provisions that allow the startup to convert the note into equity in the company, rather than paying it back in cash. In this case, the investors will not be paid back the borrowed money, but will instead receive equity in the company. If the company’s stock price increases in the future, the investors may be able to realize a profit on their investment.

What happens when convertible notes mature?

The investment is likely gone. You need to have a conversation with your investors and likely extend the maturity date.

Can a convertible note be paid back?

A convertible note can be paid back in cash, provided the startup has the ability to generate enough cash flow to do so. If the startup is successful and generates enough cash flow, it may choose to pay back the convertible note in cash at the end of the term of the note. In this case, the investors will be paid back the full amount of the borrowed money, plus any interest that has accumulated.

However, some convertible notes may have provisions that allow the startup to convert the note into equity in the company, rather than paying it back in cash. In this case, the investors will not be paid back the borrowed money, but will instead receive equity in the company. If the company’s stock price increases in the future, the investors may be able to realize a profit on their investment.

Do investors prefer convertible notes?

I am sure some investors are used to doing notes, and in many cases, they make a lot of sense, but they do raise more questions than they answer.

In a lot of cases, they are fit for purpose. In general, equity rounds provide a lot more certainty.

What is the main advantage of a convertible note?

The main advantage of a convertible note is the lack of terms for the deal including valuation. Due to this, they can be quick and cheap to complete.

The convertible note provides investors with a means of investing in startups that are not yet valued. These short-term loans are converted into equity by the issued firm. Investors loan money and repay them with equity instead of capital & interest. The notes convert automatically into equity after defining the milestone, typically when the company is officially valued for future purchases.

Convertible notes have become a widely used asset for early-stage venture funding. According to the 2020 Angel Funders report, 65% of angel investments are conducted using convertible notes. The prevalence of such tools is so great that startup investors must have knowledge of the process.