Convertible notes are among the most commonly used vehicles for early-stage companies to structure seed and angel investment.

What is a convertible note?

A convertible note is simply a loan by an investor to a startup company, which automatically converts into equity in a qualified financing round (i.e., a round above a certain size). In most cases, note investors will receive a discount on their conversion to equity in order to compensate for the risk of supporting the company so early in its lifecycle. In some instances, the noteholders might request a “price cap” to establish a maximum price at which they would be required to convert to equity. Other terms to consider include provisions for optional conversion, conversion at maturity, and premiums upon a pre-conversion sale of the company.

Convertible note documentation is relatively light and significantly standardized, and therefore – if you’re working with the right startup lawyer – cost-effective.

Convertible note advantages for startups and investors

• Relatively simple and inexpensive way to structure seed and angel investment
• Defers the determination of company valuation

Convertible note terms – an example

Let’s assume that your company raises $1,000,000 in convertible debt that has a 20% discount, with mandatory conversion upon a qualified equity financing round of at least $2,000,000. Sixteen months later, having released a product and demonstrated market acceptance, you negotiate a “Series A” investment round in which a group of local VCs will invest $4,000,000 in the company at a pre-money valuation of $12,000,000.

Since the Series A investment of $4,000,000 exceeds the qualified equity financing threshold of $2,000,000, the $1,000,000 of debt held by the noteholders will automatically convert at a 20% discount to the equity price that the Series A investors will pay. The noteholders will sign the same type and forms of agreement that the Series A investors negotiated with the company.  In the end, the VCs will own 25% of the company ($4MM/$16MM representing the post-money valuation of the company), the noteholders just under 8%, and the founders about 67%.

This simplified scenario does not address convertible note caps or issues relating to the treatment of existing or future equity options, and assumes that the conversion of the debt occurs (as is most often the case) as part of the pre-money (i.e., pre-investment) capitalization of the the company.

Can I do this myself?

No. Part of being a smart entrepreneur is understanding your strengths and appreciating where you need to rely on others to get a job done. This is one of those “rely on others” situations. An experienced lawyer will ensure that your documents clearly set out all of the necessary terms and address important related issues such as securities law compliance. In addition, having a lawyer will communicate maturity to your investors, and enable you to stay at a comfortable distance from negotiation of the legal terms.

Bottom line: Focus on your business, and find a lawyer to partner with on legal matters. That’s the wise decision.