In this case, the note will typically convert at the lower of the two options-a favorable outcome for investors. Some convertible notes will specify both a valuation cap and a discount rate. A convertible note discount rate of 30% and a priced equity round with a post-money valuation of $10M, for example, would allow noteholders to effectively invest at a $7M valuation. Instead of a specific valuation cap, a discount rate gives noteholders a discount to the valuation at the priced equity round when they convert. The lower the convertible note valuation cap, the better the terms for the investors. If the valuation cap is $5M and the priced equity round has a post-money valuation of $10M, the noteholders effectively invest as if they’re coming in at the lower valuation of $5M. This is the maximum valuation at which a convertible note will convert. The price at which the convertible note will convert to equity will be determined by one of two things: If the company does experience a conversion event, the total amount converting into equity will include the original principal amount on the note and any interest accrued to date.

In the absence of a conversion event, the convertible note functions like a traditional debt instrument, with an interest rate and a maturity date. The mechanics of a convertible note depend on whether or not the company experiences a conversion event. Both forms of financing allow investors and founders to put off the question of valuation-often a point of disagreement between founders and investors-until a later date, so that companies can get funded sooner. VCs use convertible notes for many of the same reasons they use SAFEs. As debt instruments, convertible notes also have a maturity date and can earn interest (two key differences with SAFEs, as outlined further down). After conversion, they become equity in the company. Convertible notes are recorded as debt on the company’s balance sheet up until the conversion event. So, is a convertible note debt or equity? It’s a little of both.

At some later point, such as a future fundraising round or liquidation event (acquisition, IPO, etc.), those notes will convert to equity (in other words, an ownership stake in the company)-usually in the form of preferred shares. Investors offer founders convertible notes in exchange for equity in the company. What is a Convertible Note?Ĭonvertible notes-sometimes called convertible promissory notes-are short-term debt instruments that convert to equity upon a predetermined conversion event. In this guide, we’ll cover the mechanics of convertible notes, the benefits and considerations when using them, as well as how they compare to SAFEs. Given the prevalence of these instruments, it behooves investors to know how they work. For investors, convertible notes offer strong protections and some of the same advantages as SAFEs.Ĭonvertible notes are one of the most common investment instruments when it comes to early-stage venture financing.Īccording to the Angel Capital Association’s 2020 Angel Funders Report, 37% of angel deals were done using convertible notes in 2019.Traditionally, convertible notes have been one of the most popular instruments for early-stage investing-though that’s changing with the increased popularity of SAFEs.Convertible notes are a form of debt financing that allow investors to convert their loan into equity in the event of a priced financing round or liquidation event.

Convertible notes venture capital