Convertible notes are debt instruments which convert to equity upon completion of a triggering event such as a future qualified financing round. Convertible notes are a popular investment vehicle for early stage startup companies. They are simple, cheap, and fast compared to traditional equity financing rounds and do not require a company to determine valuation or dilution at that time.
Convertible notes, like other types of loans, have a maturity date at which time the loan repayment is due. Typical maturity dates are set between 18 and 24 months from investment.
Various events can trigger the conversion of debt to equity. The most typical and advantageous for startup and investor is the initiation of a new round of equity financing. This financing round establishes a valuation for the company and the convertible notes are converted to equity at a discounted rate.
If the maturation date occurs before the next round of financing this leaves investors and the company with a variety of options:
- Company pays back the principle of the loan plus interest
- Investors extend the maturity date
- Automatically convert debt to common or preferred stock
The startup company often do not have the funds to pay back the convertible note loan plus interest and therefore would go bankrupt in this case. Thus investors and companies come to terms over extension or conversion in order to avoid this case. Conversion to equity prior to an equity round may not be favorable for the company.
Investors receive a discounted rate upon conversion to equity, for the risk taken on in the intervening time period.
The valuation cap is a predetermined maximum valuation of the company at which the convertible note investment can be converted into equity .
The interest rate determines the amount of interest accrued on the note prior to conversion or repayment.
Paul Graham declared in a tweet in August 2010 that convertibles notes had overtaken other types of early investments. Y Combinator later released the SAFE (simple agreement for future equity) as an alternative to traditional convertible notes.
