A convertible note is a way for founders to raise money for their startups before a specific valuation round.
It allows the founders to raise the needed funds faster but at a lower valuation than what they would in the next round. The investors get either a discount compared to next valuation price, or get a lower valuation.
Convertible notes are short-term debt and are converted into equity in the issuing company. In essence, investors loan money to the startup. They are repaid with equity in the company rather than principal and interest. (Warning: make sure in the terms that, the investor is not expecting to be paid back in money. )
Important Convertible Note Key Terms
Convertible Note Discount Rate.
If defined in the terms, this represents the valuation discount the convertible note investor receives relatively to investors in the subsequent financing round.
For example: If there is a 20% discount rate. In the next valuation round, instead of paying 1000$ for 1 share you pay 800$.
Note. Discount rate might not always be defined in the agreement.
Convertible Note Valuation Cap.
If defined in the terms, it caps the price at which your notes will convert into equity in the subsequent financing round.
For example: If there is a 10M valuation cap. And if in the next funding round, you decide to raise a 20M valuation round, instead of paying 1000$ for 1 share the convertible note investor gets it for the capped valuation of 10M, thus effectively pays half, or 500$.
Note. Valuation Cap might not always be defined in the agreement.
Convertible Note Interest Rate.
If defined in the terms, being a lending money mechanism, convertible notes will accrue interest. Instead of being paid back in cash, the interest increase the number of shares issued upon conversion.
For example: If there is a 5% interest rate/year. In a year your 100$ will be considered 105$.
Note. Interest rate is not always defined. The convertible note interest rate can range from 2 to 8 percent annually.
Convertible Note Maturity Date.
Convertible notes, most often, like other forms of debt have a maturity date, usually 18 to 24 months. Sometimes at maturity they automatically convert to equity, or convert to equity if the lender agrees. Otherwise, the investor and the company often try to agree on extending the term of the note to allow more time for the preferred financing to take place.