What Is a Convertible Note and Should Your Startup Issue Them for Financing?

If you’re an early-stage startup thinking about seeking venture funding, one of your biggest looming questions is, What’s my company’s valuation? That has a big effect on the kind of capital you’ll be able  to raise and from whom you’ll be able to raise it. Unfortunately, valuation is a complex issue, which is why many startups who raise angel or seed capital choose convertible notes when engaging investors.

A type of financing for early-stage companies, convertible notes are short-term loans that convert into securities down the line. Many often use these types of funding instruments before they pinpoint an exact valuation for their organization. It helps them “kick the valuation can down the road,” so to speak.

If it sounds a bit nuanced, it is—but we’ll go through what you need to know without getting too in the weeds. (You can do that with your business lawyer, since you should certainly have someone engaged if you’re raising a round.) After this, you’ll know what a convertible note is, how convertible notes work, and whether it’s a viable option for your startup at this juncture.

What’s a Convertible Note in Venture Capital Financing?

A convertible note is a type of short-term debt financing used in early-stage capital raises. In simplest terms, convertible notes are loans to early-stage startups from investors who are expecting to be paid back when their note comes due. But, instead of being paid back in principal with interest, the investor can be repaid in equity in your company.

In another way, you can think of a convertible note like an IOU. You’re giving someone who’s provided you a short-term loan a stake in your startup later in exchange for money now. The benefit in that promise for the investor is that if they give you capital and a vote of confidence early on and you do well, you’ll repay them many times over.

How Do Convertible Notes Work?

An investor will provide an early-stage startup in need of capital with a loan (in the ballpark of a standard short-term loan, usually a year or two), along with repayment terms. This is the “note.” The note will include a due date at which time it’s mature and the balance will be due, along with interest.

The idea behind convertible notes is that the company to which the note is issued is on a strong growth trajectory—amassing value for the investor and beelining to a priced round. Bottom line here is that the noteholder doesn’t want to get their loan paid back. They want their debt to convert into a heavily discounted security in a company that’s on a rocket to the moon.

Why Would You Use a Convertible Note?

Why aren’t you giving someone that equity now? This goes back to our original point about valuation… and how it’s not easy to come to. In fact, it’s quite hard to come to, and whether or not you can even raise capital at all often hinges on whether you value your company correctly. (In other words, whether you and your investors can agree.)

Particularly, if you’re in early stages—just incubating an idea, pre-revenue, or perhaps seeking financing to develop the technology on which your entire startup will hinge—slapping a number on yourself is nearly impossible. In nascent days, you likely don’t have many tangible assets, and valuing intangible assets, such as intellectual property, is a hotly contested debate. So, what now?

Convertible notes allow you and your investors to determine your valuation at a later time when you have data like growth numbers, sales, customers—anything better than a guess. Generally, this happens during another financing round. You can secure financing from investors in the form of a loan now with the likelihood of conversion into equity contingent on a future valuation.

Important Details About Convertible Note Terms

Investors interested in becoming noteholders are willing to accept the risks of financing a very early-stage startup. That means, though, that they expect the incentive that comes along with taking on that risk. This’ll be reflected in your terms.

• Valuation cap: Generally just referred to as the “cap,” the valuation cap is the value at which the noteholders’ loan (both principal and interest, which accrues as paid-in-kind) converts into equity. Even if you raise your round at a higher valuation, you agree with your investor on a maximum cap. The lower the cap, the better the terms for your investor, since they’ll reap bigger increases in your company’s value the lower their buy-in begins.
• Discount rate: Convertible noteholders are generally offered an additional discount on their share price to honor their risk. Earlier investors generally see larger discounts (25% is standard for many very early investors).

If You Don’t Raise a Round Before Your Maturity Date

There is always that possibility, as in any kind of business, that things don’t go to plan. Say you don’t get to Series A as quickly as you thought, or you were on that rocket ship to the moon and you ran out of fuel. Stuff happens.

If you don’t raise an equity round, a few things could happen:

• Your noteholder could extend your note. Maybe she’ll tell you to dust off your shoulders, keep on going, and push you toward raising that round. She might negotiate terms, increasing her discount or lowering her cap, but it’s potentially worth it if you can get your loan extended.

• Your noteholder can make you pay your loan. It is a loan, after all. If you can’t pay it, you have to declare bankruptcy.

• You can try to convert the note to equity with a new cap. If you can find a common ground that works for you both, you can convert at a different valuation than the one originally intended.

What Kind of Companies Are Convertible Notes For?

Early-stage startups in high-growth phases. Convertible notes are business financing instruments for companies in talks with potential investors at angel and seed rounds of funding. (By the time you hit your Series A, you’ll have a valuation, and convertibles won’t be relevant for you any longer. Makes sense, right?)

Plus, since these notes are debt before they convert into equity, in order for convertible notes to create any value for noteholders, your company needs to be quickly growing on the path to a priced round. Otherwise, you might be stuck paying back your debt with interest if your note reaches maturity and your investor doesn’t extend your note. Worse, you could have to liquidate your company if you can’t pay off your debts.

Convertible notes are also ideal for early-stage startups who also want to close funding fast. Because they’re really just a loan, all you need is a promissory note to get the deal done (not a long, involved term sheet as required in standard equity deals; you’ll get to that later). Additionally, you can close different terms with multiple investors with convertible notes—something you can’t do once you price your round.

Alternatives to Issuing Convertible Notes to Finance Your Startup

We do still need to mention, though, that not every startup should be issuing convertible notes to swaths of investors. In fact, not every startup should be raising venture capital at all. When you’re considering whether or not to issue convertible notes, step back for a second and make sure that you’re ready to raise capital at all.

Although it’s a good time to be a founder raising early-stage money, you should still ask yourself these questions:

1. Have I looked into any relevant grants available for my industry/sector?

There’s a lot of money out there to be had—especially for female founders, veterans, and founders of color. Along with those available for your specific type of  business, you should look at the myriad small business grants available. There are literally hundreds—and they don’t require equity or valuation.

2. Have I considered an SBA Microloan?

Especially if you business is involved in social good causes, and if you’re a founder in an underrepresented group. SBA Microloans are ideal for startups because they don’t require some of the same stringent credit requirements or extensive time-in-business history that other SBA loans do, but you can still access up to $50,000 with some of the most competitive terms available.

Plus, not only do you not have to give up equity, you’ll also avail yourself to the U.S. Small Business Administration’s famous resource network.

3. Am I definitely ready to give up equity?

The most important question of all. There are lots of reasons why many founders decide raising venture capital is right for them. Maybe you’re bootstrapping your business, for instance, and you’ve hit a point where you just don’t have access to the cash you need to keep up with your growth on your own any longer. Maybe you want a strategic partner.

Remember, though, that there isn’t just the get in this equation—there’s the give, too. In the euphoria of seeing your bank account grow and your figurative rolodex expand, make sure you’ve actually confronted the reality of giving up in perpetuity a piece of your proverbial pie.

Issuing SAFE Instead of a Convertible Note

If you still feel that raising venture capital is the way to go for your startup, and you’re comfortable with giving up equity, you have another alternative. Some founders aren’t comfortable with convertible notes because of the debt aspect—they just don’t like the idea of taking on a loan in very early stages of their company.

The SAFE (Simple Agreement for Future Equity) is meant to circumvent this. Created by Silicon Valley startup incubator Y Combinator, the YC SAFE is meant to be a very flexible, founder-friendly alternative to convertible notes with zero debt involved. The SAFE is similar to a convertible note in the sense that it’s a financing instrument with the potential to convert to equity in the future at an identified milestone (i.e. a funding round). But big differences include no maturity date or interest—which means no repayment from the startup. They can also be done with or without cap or discount.

As you’d expect, they’re significantly chancier for investors. Some VCs simply won’t participate in SAFEs due to the high risk involved. But for extremely promising companies that are in high demand, these are possible alternatives.

Issuing KISS Instead of a Convertible Note

Also, consider seed-stage VC firm 500 Startups’s KISS documents. KISS (Keep It Simple Security) works very similarly to everything you’ve read about already. These are meant to be very short, customizable documents that allow founders and investors to work out terms that are right for them.

There are KISS documents for both a debt agreement that’s closer to a convertible note, plus an equity-only agreement that’s closer to a SAFE. If you have legal counsel you trust, or you’re not quite feeling either setup, you might want to take a look into these to see if you might be able to create a more custom agreement that suits you.

Is Your Startup Ready for Convertible Debt?

If you feel like there’s a lot to think about… well, deciding whether to take on debt, raise capital, and start engaging with VCs is a lot to think about. But know you have options. And also know that there are non-convertible financing instruments—like SBA loans and grants, too—that might help you for now if you’re hesitating about what’s right for you.

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