Convertible Note
IntermediateA convertible note is a short-term loan, commonly used by early-stage start-ups, that converts into shares in the company at a later funding round instead of being repaid in cash.
Valuing a very young start-up is difficult. Convertible notes allow founders and investors to postpone agreeing a valuation until a later round, usually when professional investors set a price for the company's shares.
Convertible notes typically include several features. An interest rate accrues and converts into shares along with the principal. A discount gives note holders shares at a lower price than investors in the next round pay, rewarding them for investing early. A valuation cap sets a maximum valuation at which the note will convert, protecting early investors if the company's value rises sharply. A maturity date sets when the note must convert or be repaid.
For example, an investor puts 500,000 into a convertible note with a 20% discount. In the next round, new investors pay 2.00 per share. The note converts at 1.60 per share, giving the investor 312,500 shares, ignoring interest.
Convertible notes are quicker and cheaper to arrange than equity rounds. A similar instrument without interest or a maturity date, called a simple agreement for future equity, has become widely used in the United States and elsewhere.
For worked examples and full lessons, visit notesbysara.org.