Convertible Notes for Startups: Financing Guide + Legal Support
While raising capital can be one of the most exhilarating parts of launching a startup, it’s also among the most nerve racking, especially when you’re trying to determine which funding instruments are right for your business. For many early-stage founders seeking a faster path to capital without immediately committing to a valuation, two alternatives are the SAFE and the convertible note. While SAFE’s are used more frequently now than convertible notes for pre-seed and seed stage financings, certain investors still insist on using a convertible note over a SAFE. It is therefore important for founders to understand convertible notes
At NEXT, our experienced lawyers have guided founders through countless convertible note transactions, and we’ve acquired a deep understanding of the opportunities and risks this financing instrument presents. So what exactly is a convertible note financing, and is it the right choice for your business? Let’s break it down.
What Are Convertible Notes?
A convertible note is a form of short-term debt that “converts” into equity at a later date. Essentially, an investor lends money to a startup with the understanding that instead of being paid back in cash, the loan will convert into company shares during a future funding round.
Because it’s a debt instrument, a convertible note includes standard loan terms like an interest rate and a maturity date. However, its primary purpose is not to be repaid, but to serve as a bridge to a priced equity round in the future, such as a Series A round. This allows founders to delay the difficult conversation about valuation until their startup has more traction and a clearer growth trajectory.
The Convertible Note Agreement
If you’re considering convertible note financing, it’s important to understand the key terms in a convertible note agreement, which sets parameters for the future conversion of the debt into equity.
Interest Rate
Like any loan, a convertible note accrues interest. This interest is typically simple, not compounded, with rates often falling between 5% and 8% annually. The accrued interest is usually added to the principal investment and converted into equity along with the original loan amount, rather than being paid out in cash.
Conversion Triggers
A “qualified financing round”—often a Series A—is typically what prompts a convertible note to convert into equity. Some notes convert automatically once certain conditions are met, such as a preferred stock financing with a defined minimum amount raised, while others give investors the choice to convert.
Maturity Date
The maturity date is the date when the convertible note is due for repayment if it has not already converted to equity. This is typically set for 18 to 24 months after the investment. If the startup hasn’t raised a qualified financing round by this date, the investor may have the option to have the loan repaid (with interest) or convert the note into equity at a pre-negotiated valuation. However, in many cases, the parties will negotiate an extension of the maturity date.
Valuation Cap
A valuation cap sets the maximum company valuation at which the investor’s note will convert into equity. For example, if a note has a $5 million valuation cap and the company raises its next round at a $10 million valuation, the noteholder’s investment will convert as if the valuation were only $5 million, granting them more shares as a reward for their taking more risk for having invested at an earier-stage.
Discount Rate
The discount rate offers the investor a discount on the share price of the future equity round. This is another way to reward early investors for taking a risk before the company’s value was established. Discount rates typically range from 15% to 25%. If the priced round sets a share price of $1.00, an investor with a 20% discount would convert their note into shares at a price of $0.80 per share. If a convertible note has both a Valuation Cap and a Discount Rate, the Investor will only receive one or the other in a conversion event (whichever is better).
Advantages of Convertible Note Financing
Some of the world’s most recognizable companies, including Airbnb, Uber, and Dropbox, relied on convertible note financing in their earliest stages. It’s easy to see why: convertible notes provide a streamlined way to raise capital while reducing the uncertainties that often accompany an early-stage deal.
How Founders Benefit from Convertible Notes
Faster Access to Capital
Convertible notes typically involve less complex negotiations than equity funding rounds. Because the startup is not immediately selling equity, there’s no need for extensive valuation discussions, detailed term sheets or extensive documentation that characterize traditional priced round investments. This efficient path to funding leaves you free to focus on growing your business
Reduced Legal Costs
The documentation required for convertible notes is generally much simpler than for a priced equity financing . While it’s wise to work with an experienced convertible note lawyer, with fewer terms to negotiate and standardized conversion mechanisms, legal fees are typically lower than those associated with priced equity rounds.
Delayed Valuation Discussions
Early-stage companies often lack sufficient revenue or traction to support accurate valuations. Convertible notes allow you to raise seed capital now and establish your company’s value later, when you have more business metrics and market validation to support your valuation.
Flexibility
Convertible note financing can accommodate many scenarios and growth trajectories that might be difficult to address with traditional equity financing. For instance, you can negotiate different maturity dates, interest rates, or conversion triggers, creating a funding structure that aligns precisely with your strategic goals and the investor’s risk appetite.
What Investors Like About Convertible Notes
Upside Potential
The inclusion of a discount rate and valuation cap within convertible notes allows investors to convert their investment into equity at a more favorable valuation than later-stage investors, effectively granting them a larger ownership percentage for the initial risk undertaken. This benefit is particularly attractive in the high-growth startup environment, where early entry can lead to significant returns.
Downside Protection
In the event of liquidation prior to the note’s conversion, the investor holds a senior claim on the company’s assets compared to equity holders. This preferential treatment helps mitigate the potential for losses, offering a more secure position should the startup not succeed as anticipated.
Lower Valuation Risk
Convertible notes delay valuing a startup until a later funding round. This benefits investors by avoiding the difficulty of valuing a new company with little history. The actual valuation happens when the company has a clearer performance and market position, which reduces the risk of overpaying early on.
Risks of Convertible Notes
While convertible notes are often the best choice for early-stage funding, they do come with certain risks founders need to be aware of:
- Maturity Date: If your startup fails to secure a priced funding round before the note matures, you could be required to repay the loan along with accrued interest.
- Dilution: If a note converts during a high-valuation funding round, early investors may receive a significant equity stake, resulting in unexpected dilution of your shares.
- Accumulation of Debt: Raising multiple rounds of convertible notes can lead to a complex “stack” of debt that could complicate your future financing rounds.
- Dependence on Future Funding Rounds: Convertible notes typically convert to equity during a future financing event. However, if you struggle to secure additional funding, repayment may become due, putting pressure on your company’s cash flow and potentially leading to default.
- Loss of Negotiating Leverage: Delaying valuation negotiations until a later round can backfire if company performance does not meet expectations, putting you at a disadvantage when notes convert.
- Risk of Noteholder Control: Convertible notes may include provisions that grant holders certain rights, such as the ability to influence the business or block specific actions, which can complicate decision-making and reduce your independence.
Convertible Note FAQs
What is the difference between a SAFE and a convertible note?
Because it’s not a debt instrument, a Simple Agreement for Future Equity (SAFE) lacks both an interest rate and a maturity date, making it particularly founder-friendly. A convertible note, however, does have a maturity date and an interest rate. It also requires repayment or conversion to equity, offering an investor more protection.
Do I need a lawyer for a convertible note?
It’s a good idea to retain an experienced startup lawyer to ensure all documents are drafted correctly, the company’s interests are protected, and potential liabilities are mitigated. A convertible note lawyer can also provide guidance on terms and assist in the process of securing funding without an immediate valuation.
What are typical convertible note terms for startups?
Convertible notes typically include terms such as a maturity date for repayment, an interest rate for accruing the loan principal, a valuation cap to set the maximum conversion valuation, and a conversion discount that allows investors to convert their debt into equity at a reduced share price. While the exact values are negotiable, they generally adhere to industry standards.
NEXT’s Fixed Fee Convertible Note Packages
NEXT has developed a comprehensive fixed fee Convertible Note Package that includes:
- Strategic guidance on the financing process
- A review of prior corporate documents for existing investor rights
- Preparation and negotiation of the Term Sheet
- Preparation and negotiation of Convertible Note Purchase Agreement and Convertible Notes
- Preparation of Corporate Resolutions
- Preparation of Accredited Investor Questionnaire
- Management of the Closing
- Federal Level – SEC Securities Filings
- State Level Securities Filings
