A convertible note is essentially a loan to a company, with the added feature that the loan can be converted into equity at a later date. The loan typically has a fixed term, with interest accruing on the outstanding amount. The note holder, or the investor, has the option to convert the loan into equity at a later date, usually when the company raises a new round of funding at a higher valuation.
The conversion of the loan into equity is usually done at a pre-agreed conversion price, which is typically a discount to the price per share of the new round of funding. This is done to compensate the early investors for the risk they are taking by investing in a startup at an early stage.
Convertible notes are popular among startups and early-stage companies because they allow them to raise capital without having to value the company at an early stage. This is particularly useful for companies that are not yet generating revenue or are in the very early stages of development.
It is worth noting that convertible notes can also have a maturity date, which means that if the company doesn’t raise a new round of funding by that date, the note holders can either convert the loan into equity or demand repayment of the loan. Additionally, convertible notes may also have a cap feature which determine the maximum valuation that the note will convert into equity.
Convertible notes have become a popular instrument for early-stage fundraising in recent years, but it’s important to note that they are not suitable for all types of companies and investors. It is important to carefully review the terms of the convertible note before investing and to have a clear understanding of the risks and rewards associated with this type of investment.