What Founders Need to Know About Convertible Notes: Discounts, Caps, and More

If you are an early-stage founder looking to quickly and efficiently raise capital for your startup, the convertible note may be the perfect vehicle to secure your investment. A convertible note or convertible debt is a loan that can be converted into capital when certain events occur. Until then, a convertible note is simply a business loan that accrues interest.

Convertible Notes can be a great option because they:

Are quick and easy Are familiar to lawyers and investors Delay evaluation until next funding round

Getting funded through a convertible note is easier and faster than trying to raise funds through an equity round. It's a great way to get your first funding as you build your minimum viable product.

When companies use convertible bonds, they get into debt. This is a key difference between convertible debt and a simple agreement for future equity (SAFE). Convertible notes are loans that bear interest and must be repaid if not converted. In contrast, SAFEs do not earn interest and generally do not need to be repaid if not converted.

The term sheet provides a summary of the main points of the transaction. Most of the negotiations between you and your investor will take place at the term sheet level. Once both parties are aligned on the term sheet, the attorney will draft the agreement documents. Below are the key points of the agreement below so you can enter the negotiations with confidence.

Due date

The maturity date is the deadline for repayment of the loan and accrued interest. It is usually between 18 and 36 months after signing the convertible note, although the time frame can be negotiated depending on the situation. Unlike a car loan or a student loan, convertible notes do not have fixed monthly payments. Instead, the company usually has to repay the full amount - principal plus interest - on the due date if it doesn't convert first. With convertible notes, the clock is always ticking. Smart founders who decide to use a convertible note tend to set the maturity date well after their next scheduled fundraise.

Usually, investors in convertible bonds are not large banks or traditional investors. Often these are individuals, such as angel investors, who strongly believe in your vision. In theory, they could force you to liquidate the business if you cannot pay the principal and interest when due. However, this rarely happens. Instead, the founder and the investor usually negotiate the terms to extend the maturity date of the loan. Nevertheless, you should not take these loans lightly.

interest

The interest rate is the amount you pay the investor to use their money now to earn your own money later: a simple interest rate, usually between 4% and 6%.

Conversion

In a convertible note, the loan will be converted into equity when you raise what is called qualified financing. A qualified financing is an equity financing (not a round of SAFE or convertible notes) above a certain threshold, usually $1 million. When you raise qualified financing, the debt will be converted into preferred shares of your company.

But how will it be converted? What is the formula you will follow to make this conversion? The number of preferred shares that investors in convertible notes will receive will depend on the existence of a haircut and/or cap.

Discount

The discount rate, typically 15% to 25%, is applied to the new investor's price per share. For example, suppose your convertible note has a 20% discount and new investors pay $1 per share. The convertible note investor will convert at $0.80 per share. This means that if the convertible note investor invested $100,000, they would receive 125,000 preferred shares instead of the 100,000 shares they would have received had they invested in the qualifying financing.

Assessment ceiling

One of the most traded terms in convertible bonds is the valuation cap, sometimes referred to as a price cap or simply cap.

What is a valuation cap and why is it getting so much attention? A valuation cap is the highest value...