Convertible Note: What It Is, How It Works, and Key Terms

Learn about the Convertible Note, a debt investment instrument designed to make fundraising easier for startups. In this article, you’ll learn everything you need to know about this convertible investment instrument and decide whether it’s the best option for your startup. 

This content, created in collaboration with Lazo, covers the following topics:

• What is a convertible note?
• Convertible note terms
• Conversion events
• Investor rights in a convertible note
• Convertible note example
• Benefits and drawbacks of a convertible note
• Convertible note template
• Conclusions

What is a convertible note?

A Convertible Note is an investment instrument created to help startups raise capital quickly and easily. 

This instrument is a loan whose primary purpose is to convert into shares in the company in the future. In other words, although it is a loan, its main purpose is not to be repaid but to convert into shares.

Since it is a loan, it is considered debt, and like all debt, it accrues interest.

Convertible note terms

Here are the most common terms and conditions you’ll find in a convertible note.

• Investment. The amount to be invested.
• Maturity date. The time at which the instrument “matures” and repayment plus interest or conversion into shares must be considered. This period usually ranges from 18 to 24 months.
• Interest. The annual interest that accrues on the loan. The standard rate ranges from 8% to 12%.
• Valuation cap. The maximum valuation at which the investor will convert their investment into shares in the future. In other words, the cap on the price per share.
• Discount. A discount on the price per share that may be granted to the investor as a benefit for investing at an early stage. The standard percentage is usually 20%.
• Conversion event. Clauses that define when the investor may convert their investment.
• Investor rights. Rights the investor will have as part of the investment.

Conversion events

When will the investor receive shares in the company?

Also known as conversion events, these are the “triggers” that cause the convertible note to convert the investor into a shareholder or a creditor of the company. The most common conversion events are:

• Equity round – Series A. Also known as a “priced round,” this is when the company raises an investment round at an actual valuation, exchanging shares for money. This round typically takes place at Series A.
• Maturity date. Once the maturity period has passed, the investor and the startup must decide on one of the following scenarios: convert into shares using the valuation cap, collect repayment of the debt, or extend the maturity date by 12 more months. If the maturity date is extended, the investor may negotiate new benefits.
• Company acquisition. That is, in the event of an “exit.” In this case, the standard is to repay the investment at 2X plus interest at 2X.

Investor rights in a convertible note

Some of the most common rights an investor might negotiate in a convertible note are:

• Information rights. The investor’s right to request accounting, financial, or legal information, or some type of report every Q or at another specified interval.
• Observer rights. The investor’s right to “observe” or listen to board meetings. In other words, they may participate in the board meeting without speaking or voting, but may listen. 
• Pro rata participation. The investor’s right to participate in the next investment round to maintain their ownership percentage.
• Most Favored Nation (MFN). A clause that gives the investor the right to match benefits granted to another investor in subsequent rounds, provided those benefits are better than the ones the investor signed up for. 

Keep in mind that investors may request other benefits, but these are the most common.

Convertible note example

What would the conversion of a convertible note look like in practice? Let’s take a look at an example.

1. In this example, investor Brenda invested US $500K at a cap of US $3M, with a discount of 20% and annual interest of 5%.
2. Two years later, the startup raises a Series A round of US $1M at a cap of US $5M.
3. At that point, the startup had issued 5M shares, resulting in a price per share of US $1 for the Series A investor.

How would investor Brenda convert her convertible note?

Applying the 20% discount to the price per share paid by the Series A investor, which is US $1, Brenda would pay US $.8 per share.

Applying the 5% annual interest to the US $500K Brenda invested would convert her investment into US $525K. This amount would buy 656,250 shares in the company, representing 13.1% of the company.

How would Brenda’s conversion work if she used the valuation cap instead of the discount?

1. Instead of dividing the 5M shares by the US $5M valuation at which the Series A investor will invest, 
2. we divide the 5M shares by the US $3M valuation cap Brenda signed with the startup. 
3. In this example, Brenda would pay US $.6 per share, allowing her to buy 875,000 shares, or 17.5% of the company.

In the example above, Brenda would convert her Convertible Note using the valuation cap rather than the discount, since that conversion method gives her a greater benefit.

Keep in mind that the investor will convert their Convertible Note (investment plus interest) into shares using either the discount or the valuation cap, always choosing the term that results in the greatest number of company shares.

Benefits and drawbacks of a convertible note

Like every instrument, the convertible note has advantages and disadvantages. Learn about them below:

Benefits:

• Quick injection of capital.
• Lower legal and corporate costs compared with an equity round.
• The investor receives a preferential price compared with the Series A round.

Drawbacks

• It is a loan and therefore a liability for the company.

Conclusions

Keep in mind that there are other convertible instruments for startups. Depending on your needs, you should choose the one that best suits them. We also recommend always consulting a lawyer about these matters.