Updated: June 30, 2021
You just heard about a budding business and you’re looking to invest. You’re excited to help the young company grow, so you agree to lend some money. The owners are ecstatic! They send you what’s called a “convertible note” – what is this?
If you’re an investor that’s been presented with a convertible note, this article is for you. If you’re the owner of a startup, you may want to check out our post on Convertible Debt from a business owner’s perspective.
This article will cover some of the key questions you’re probably thinking about:
A convertible note is a financial instrument that represents convertible debt, an investment in the form of a loan which later converts into an equity stake in the company if the business takes off. It’s where you, the investor, agree to lend money to a new business, in exchange for one of two outcomes: (i) if the company does well, you get to convert your investment into an ownership interest; and (ii) if the company doesn’t do so well, you can still get your money back as if it were a regular loan. Startups turn to convertible debt because it gives them access to relatively quick loans with low interest rates from private investors – but it’s important to know why you may also want a convertible debt structure.
As an investor, there are some terms you may want to pay particular attention to: (i) the interest rate; (ii) the conversion discount; and (iii) the valuation cap.
Because the convertible note starts as a loan, it will typically include an interest rate. This interest rate will apply if the company doesn’t move forward, and ends up giving you back your money before it can be converted into equity. The typical interest rate you’d see in a convertible note ranges from 4% to 12%. Although the interest rate will give you some profit on your money, what you really want (and what you’re hoping for) is a greater return on your money if the company does well. This is where the conversion discount and valuation cap come in.
When you’re out shopping, you may hear a sales associate say, “If you spend $100 today, you get 20% on your next purchase!” That’s kind of how the conversion discount works – you pay up now, and receive a discount in the future. Let’s look at an example: you invest $10,000 in a company and you’re offered a 20% conversion discount in your convertible note. You hear that business is going great, and six months down the line the company brings in Series A investors. You also hear that these Series A investors are paying $1 per share to get in. Good news – you’re only paying 80 cents per share! So where a Series A investor only gets 10,000 shares for their $10,000, you get 12,500 shares for the same price.
Typically, the convertible note will convert your investment to shares either at the conversion discount, or in accordance with a valuation cap (usually the option that costs you less will apply). The valuation cap puts a ceiling on the value of the company, so that the price you pay per share doesn’t overinflate if the company value skyrockets. For example, let’s say your convertible note has a $3 million valuation cap. The company does a Series A round of funding, and it’s determined at that later time that the company is worth $6 million. The Series A investors are paying $1 per share, but because your investment will convert as if the value is $3 million, you pay less – half the value, half the price. So, you’re only going to pay 50 cents per share. Where the new investors get 10,000 shares for $10,000, you get 20,000 shares!
When you invest in a new company, you’re taking a huge risk. In its early stages, it’s hard to determine the value of the business, so you don’t really know what you’re putting your money down for. But with a convertible note, you have a safety net. Even if the company doesn’t grow in value, at the very least you’re entitled to your money back with some interest on top.
While it’s nice to know that you’ll get some interest on that returned loan, the real upside is where the company grows into a successful business. With the right conversion discount, and a favorable valuation cap, there’s potential to make some good money.