What are Convertible Notes?

Until 2023, access to capital was cheap, leading to increased funding for companies, soaring valuations, and heightened competition in funding rounds. However, as inflation rose due to multiple macroeconomic factors, the cost of capital continued to rise, making Venture Capitalists (VCs) more conservative and selective in their investments.

As a result, in 2023, there was $170.6 billion of VC money invested across 15,766 deals, which was well below the $242.2 billion of VC money invested across 17,592 deals in 2022. In fact, 2023 deal values were about $177 billion below the record levels achieved in 2021.

Fortunately for founders, there are still opportunities to fundraise. However, the rules of the game have changed—instead of getting a set ownership stake in the company right away, investors are preferring to invest via convertible debt.

This reflects in the data from Dealogic, US companies have issued more than $40 billion of convertibles across 63 deals in 2023. That’s up from $29 billion and 54 transactions in all of 2022.

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What are convertible notes?

A convertible note is a type of short-term debt instrument used by startups to raise capital during early-stage funding rounds. Unlike traditional loans, convertible notes are intended to convert into equity at a future date, typically during a subsequent funding round, rather than being repaid with interest.

For founders, convertible notes take the pressure off of setting a company valuation immediately. With stock prices fluctuating in an uncertain market, a traditional funding round might mean selling shares for less than what they're worth. A convertible note gives the startup more time to prove itself and potentially command a higher valuation later, when the market (and investor confidence) recovers.

For investors, convertible notes offer a safety net. They get a discount on the price they'll pay for shares when the note converts. Additionally, the note often accrues interest, so they're getting a return on their investment even if the startup doesn't take off.

How do convertible notes work?

Suppose you're starting a tech company called Acme, and you need $50,000 to develop your first product. You find an investor, Sarah, who likes your idea but doesn't want to buy a share of your company right away. Instead, Sarah offers to lend you $50,000 through a convertible note.

Here's how the convertible note might work:

‍1. Agreement

You and Sarah agree that she will lend you $50,000 with an interest rate of 5% and a maturity date of two years. You also agree that when Acme raises its next round of funding, Sarah's loan will convert into shares of the company at a 20% discount to the price per share in that round.

2. Lending

Sarah gives you the $50,000, and you use it to develop your product.

3. Conversion

A year later, Acme raised $1 million in a Series A funding round from venture capitalists. The price per share in this round is $1. Now, because of the terms of the convertible note, Sarah's loan converts into shares at a 20% discount to this price.

• Without the discount, each share in the Series A round costs $1.
• With the 20% discount, each share for Sarah's conversion costs $0.80.

So, Sarah's $50,000 loan converts into 62,500 shares ($50,000 / $0.80 per share).

4. Ownership

After conversion, Sarah now owns 62,500 shares of Acme, which represents a certain percentage of the company, depending on the total number of shares outstanding.

5. Repayment or conversion

If Acme hadn't raised more money within the two-year period, the convertible note would have matured. At that point, you would either repay Sarah the $50,000 with interest, or if both parties agreed, the loan could convert into shares based on the terms outlined in the agreement.

In this example, the convertible note allowed Acme to get the funding it needed without giving away equity right away, and it provided Sarah with the opportunity to invest in the company early on, potentially leading to a higher return on her investment if Acme succeeds and its value increases over time.

Terms of convertible notes

The terms of convertible notes typically include:

‍1. Principal amount

This is the amount of money that the investor lends to the startup.

2. Interest rate

The interest rate determines how much interest accrues on the principal amount over time. Convertible notes usually have a fixed interest rate, although it may be lower than typical loan rates due to the higher risk associated with startups. This reflects that investors are willing to accept lower returns in exchange for the potential upside of converting their investment into equity if the startup succeeds.

3. Maturity date

This is the date by which the loan must either convert into equity or be repaid by the startup. If the startup hasn't raised another round of funding by the maturity date, the investor may have the option to demand repayment of the loan.

4. Conversion trigger

Convertible notes typically convert into equity upon the occurrence of a specific event, such as the startup raising a subsequent round of financing above a certain threshold (e.g., Series A round of at least $1 million). This event is known as the conversion trigger.

5. Conversion price

The conversion price determines how many shares the investor will receive when the note converts into equity. It's usually based on the valuation of the subsequent financing round, with a discount or valuation cap applied to benefit the investor.

‍6. Discount rate

If a discount rate applies, the investor receives shares at a predetermined discount to the price per share in the subsequent financing round. For example, if the discount rate is 20% and the subsequent round's price per share is $1, the investor would convert their note into shares at $0.80 per share.

‍7. Valuation cap

A valuation cap sets the maximum valuation at which the convertible note will convert into equity, regardless of the valuation of the subsequent financing round. This protects the investor from excessive dilution if the startup achieves a high valuation in the future.

Benefits of convertible notes

Convertible notes are used for several reasons:

1. Flexibility

Convertible notes provide flexibility for both startups and investors. Startups can raise money without immediately determining a valuation, which can be challenging in the early stages when the company's value is uncertain. Investors can provide funding without needing to negotiate the terms of equity ownership upfront.

‍2. Speed

Compared to negotiating equity deals, convertible notes can be quicker to set up, allowing startups to access funding faster. This speed is valuable in fast-moving industries where timing is crucial.

3. Deferred valuation

Since convertible notes convert into equity at a future funding round, they defer the valuation of the company until it has more metrics, traction, or revenue, making it easier to attract investors who may be hesitant to invest based on early-stage valuations.

‍4. Mitigated risk

Convertible notes allow investors to participate in a startup's growth potential while mitigating some of the risks associated with early-stage investing. If the startup fails to raise further funding or does not perform well, the convertible note holder may have priority over other creditors in recovering their investment.

5. Incentivizing early investment

Convertible notes often include features such as discount rates or valuation caps, which incentivize early investors by offering them more favorable terms compared to later investors. This can attract investors who want to get in early but are wary of the risks associated with early-stage startups.

‍6. Simplicity

Convertible notes are often simpler and require less documentation compared to equity financing rounds, which can reduce legal costs and administrative burdens for both startups and investors.

Drawbacks of convertible notes

While convertible notes offer numerous benefits, they also come with some drawbacks for both startups and investors:

1. Uncertain valuation

Convertible notes delay the valuation of the company until a future financing round. This uncertainty can make it challenging for startups to plan and for investors to assess the potential return on their investment.

2. Conversion risk

There is a risk that the startup may fail to raise additional funding before the maturity date of the convertible note. In such cases, the note may either remain outstanding with no clear path to conversion, or the startup may be required to repay the principal amount plus accrued interest, placing financial strain on the company.

Can a convertible note be paid back?

Yes, convertible notes can be paid back by the startup under certain circumstances. Typically, convertible notes include provisions that allow for repayment in the event that the conversion trigger is not met before the maturity date.

Here are a few scenarios in which a convertible note might be paid back:

1. Maturity date reached

If the maturity date specified in the convertible note arrives and the startup has not raised a subsequent funding round triggering conversion, the note may require repayment. At this point, the startup may be obligated to repay the principal amount of the note, along with any accrued interest.

2. Mutual agreement

Sometimes, the startup and the investor may mutually agree to repay the convertible note instead of converting it into equity. This could happen if the startup no longer needs the funds or if the terms of conversion are not favorable for either party.

3. Change in circumstances

If there is a significant change in circumstances, such as a material adverse event affecting the startup's prospects or a change in the investor's situation, the parties may decide to repay the convertible note instead of proceeding with conversion.

It's important to note that the terms of repayment, including the timing and conditions, are typically outlined in the convertible note agreement. Both the startup and the investor should carefully review these terms to understand their rights and obligations regarding repayment. 

Additionally, repayment of a convertible note may have tax implications, so it's advisable to consult with legal and financial advisors before making any decisions.

SAFEs Vs convertible notes

SAFEs (Simple Agreements for Future Equity) and convertible notes are both popular instruments used by startups to raise capital in the early stages of their development. While they serve similar purposes, there are some key differences between the two:

‍1. Legal structure

Convertible notes are debt instruments, meaning they represent a loan from the investor to the startup, with the expectation that the loan will convert into equity in the future. On the other hand, SAFEs are not debt instruments and do not accrue interest or have a maturity date like convertible notes. Instead, they are structured as a promise to issue equity to the investor at a later date, typically upon the occurrence of a specific triggering event.

2. Conversion trigger

Convertible notes typically convert into equity upon the occurrence of a specific triggering event, such as a subsequent equity financing round above a certain threshold (e.g., Series A round of at least $1 million). In contrast, SAFEs often convert into equity at the next qualified financing round, but they may also have other triggering events, such as a change of control or dissolution of the company.

An equity financing round refers to any round of funding in which a company issues equity (ownership shares) in exchange for capital. On the other hand, a qualified financing round is a specific type of equity financing round that triggers certain conditions outlined in agreements such as convertible notes or SAFE (Simple Agreement for Future Equity). In essence, while all qualified financing rounds are equity financing rounds, not all equity financing rounds are qualified financing rounds.

3. Interest and maturity 

Convertible notes accrue interest over time and have a maturity date by which the loan must either convert into equity or be repaid by the startup. SAFEs do not accrue interest and do not have a maturity date, providing greater flexibility for both parties.

4. Terms and complexity

Convertible notes tend to have more complex terms, including interest rates, maturity dates, conversion discounts, and valuation caps. SAFEs are generally simpler and more standardized, with fewer terms and less negotiation required.

5. Investor protection

Convertible notes offer more protection for investors in the event of a down round or other adverse circumstances, as they have priority over equity holders in repayment. SAFEs do not offer the same level of protection, as they do not represent debt and do not have a repayment obligation.

Learn more about pre-money and post-money SAFEs.

Overall, both convertible notes and SAFEs offer advantages and disadvantages for startups and investors, and the choice between the two depends on the specific circumstances of the fundraising round and the preferences of the parties involved.