Convertible Note
What is a Convertible Note?
A Convertible Note is a type of short-term debt instrument that converts into equity (shares) in the future, typically during a later funding round. Instead of repaying the loan in cash, the investor gets shares in the company, usually at a discounted price.
It is commonly used in early-stage startup financing, where it’s hard to determine the company’s valuation.
Why Use a Convertible Note?
Startups use convertible notes to:
- Raise funds quickly without setting a fixed valuation
- Delay complex equity negotiations
- Offer early investors a reward in the form of discounts or valuation caps when the company raises equity in the future
Key Features of a Convertible Note
- Principal Amount: The amount of money loaned to the company by the investor.
- Interest Rate: Since it starts as debt, a convertible note may carry an interest rate (e.g., 6-8%). This interest is usually added to the principal before converting into shares.
- Maturity Date: The date when the note becomes due. If not converted by then, it may be repaid or convert into equity automatically.
- Conversion Trigger: The event (usually the next qualified funding round) that causes the note to convert into equity.
- Discount Rate: A percentage discount (e.g., 20%) on the price per share paid by new investors during the next funding round. It rewards early investors for taking more risk.
Example:
If new investors pay ₹100 per share, note holders with a 20% discount will convert at ₹80 per share.
- Valuation Cap: A maximum company valuation at which the note will convert, protecting early investors if the company’s value shoots up before conversion.
Example:
If the valuation cap is ₹10 crore and the company raises funds at ₹20 crore, note holders will still convert as if the company were worth only ₹10 crore, giving them more equity.
Benefits of Convertible Notes
- Simple and fast to execute compared to equity deals
- Delays valuation discussions until the company matures
- Incentivizes early investors with discounts and valuation caps
- Cost-effective for startups with limited legal budgets
Risks and Limitations
- If not clearly structured, notes can lead to dilution disputes
- Debt may become due if no qualifying round occurs
- Too many convertible notes can complicate future funding rounds