Convertible Note Meaning
A convertible note is a short-term debt security usually issued by a startup to raise capital from early (seed and angel) investors. It is called ‘convertible’ because the investors expect the note to be converted into equity in future instead of getting back their principal plus the associated interest. Convertible notes are also called convertible debt, convertible promissory notes, bridge notes or converts.
Noteholders will usually receive equity during Series A financing or a company sale. The price noteholders get at conversion is lower than that issued to the Series A venture capital investors.
Convertible notes have the following major terms:
- Principal amount due on maturity. On maturity, the investor can roll over and extend it or opt to convert it to equity if a Series A funding round has occurred.
- Fixed interest accruing on the principal.
- Conversion discount rate for the shares the investor will get on note maturity.
- Claim on company assets that’s senior to all equity holders.
Convertible notes are the most widely used debt instrument for fundraising at a startup’s seed round shortly after the company’s formation. They are preferred because:
- Lower administrative and legal costs than subsequent funding rounds.
- Simpler and quicker negotiation.
- Faster access to funding.
- Founder retains complete control for as long as the debt has not been converted to equity.
- It does not require the investor or the issuer to determine company valuation at the time of the transaction. Valuation occurs at the Series A round.
While it is in principle a debt instrument, many startups see it as unpriced or deferred equity. Investors in convertible notes see the note’s features as its most important provision since it is the mechanism through which they eventually become company stockholders.