Glossary - Convertible Note
A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round; it is often used by startups when the valuation of the company is not clear. Essentially, investors lend money to a startup as a loan, which instead of being paid back in cash, converts into shares of preferred stock during a subsequent financing round, usually at a discounted rate.
Also known as
- Convertible debt
- Convertible security
- Convertible loan
Use cases examples
- Term Sheet: The company secures a $500,000 investment through a convertible note, specifying a conversion discount of 20% on the next financing round.
- Convertible Note Agreement: The agreement stipulates an interest rate of 5% annually and includes a valuation cap of $5 million, ensuring the investors' conversion rate does not exceed this pre-determined company valuation.
Considerations for investors
- Assessing the risk of the startup's future valuation and if the terms of the convertible note adequately compensate for this risk.
- Evaluating the financial and operational health of the company to ensure the likelihood of a future financing round that will trigger conversion.
Considerations for founders
- Understanding the impact of the valuation cap and discount rate on future ownership – ensuring not too much equity is given away.
- Being aware of the interest accruing on the note and how it adds to the debt that will convert into equity.
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