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Corporate & Tax

How Do Convertible Notes Work?

08/30/2021

Although the challenges facing startup companies vary by industry, product, or service, in my experience, the one constant at the top of the list is always the same: FUNDRAISING.  The period during which founders can self-fund or “bootstrap” also varies, but sooner or later a decision is made to seek outside funding.  Typically at this point in time, the company and/or the product or service is not yet ready to raise money from venture capitalists or even angel investors, but friends and family will often consider investing.  This so-called “friends and family” financing typically takes shape in the form of either Convertible Notes or “S.A.F.E.”.

While many founders have heard the phrase “convertible note round,” I am often asked the question “What does this mean? and “How does it work?”

WHAT IS A CONVERTIBLE NOTE?

A convertible note is comprised of two components: the note and the conversion feature.  Let’s take these one at a time.

  1. Put simply, a note, or more formally, a promissory note, is a piece of paper that says one person (the Borrower) promises to pay another person (the Lender) a certain amount (the Principal) plus a percentage per month or year (the Interest Rate) over period of time ending on a particular date in the future (the Maturity Date).  Common examples of promissory notes are the agreement of Borrowers to pay back a bank money lent to purchase a home or a car.
  2. The conversion feature adds an additional layer to the traditional promissory note pursuant to which the lender can “convert” the repayment obligation of the Borrower into stock in the Borrower company.  Upon conversion, the Lender becomes a stockholder in the Borrower company.

HOW DO CONVERTIBLE NOTES WORK?

Let’s again break this apart into the two main components described above.

  1. Unless the conversion is triggered pursuant to the terms set forth in the agreement, the note is just that, a debt instrument accruing interest that will become due and payable at the Maturity Date.
  2. If, prior to the Maturity Date, one of the scenarios described below is triggered, the note is transformed into equity in the company based on conversion terms set forth in the note. 

CONVERSION TRIGGERS

  1. Qualified Financing Transaction.  Convertible notes typically provide for automatic conversion upon occurrence of a company’s next financing following the convertible note round resulting in proceeds to the company in excess of a certain minimum amount (the Qualified Financing).  Upon the occurrence of a Qualified Financing, the Lender’s principal plus accrued interest will convert into the securities being sold in the Qualified Financing at a price per share (the Conversion Price) determined by one of two calculations: the Valuation Cap and the Discount.
    • Valuation Cap.  The “Cap” is a negotiated dollar amount representing the maximum total value of the Company to be used for purposes of calculating the Conversion Price.  When using this method, the Conversion Price is determined by dividing the Cap by the total number of issued and outstanding shares of stock at the time of conversion.
    • The Discount.  The Discount is simply a percentage (typically 80-85%) of the price per share paid by the investors in the Qualified Financing.  

Although convertible notes may only include a Cap or a Discount, they often include both. In this case, the lower of the two calculations are used to determine the Conversion Price.

  1. Sale of the Company.  If, prior to the Maturity Date or the occurrence of a Qualified Financing, the company is sold, the Borrower company agrees to pay the Lender, in lieu of conversion or payment of principal and interest at the Maturity Date, an amount equal to a multiple of the principal and accrued interest at the time of such sale of the company.
  2. Optional Conversion. Although less common, some convertible notes will also provide for optional conversion at the election of the Lender.  This feature permits the Lender to convert the note, under certain circumstances outside of Qualified Financing, into an existing or new series of preferred stock, typically in accordance with the same terms as in a Qualified Financing.

CONCLUSION

The convertible note is a tried and true method for obtaining capital from non-institutional investors who may or may not be comfortable with other forms of “friends and family” investment vehicles like the S.A.F.E. 

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