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Convertible notes are the investor-friendly version of SAFEs, with the addition of features designed to enhance investor interests like maturity dates and interest rates. They are at their core simply a loan from an investor to an early-stage company. The problem is that loaning to pre-revenue and pre-profitability companies is a risky endeavor because they rarely have the cash on hand to pay back investors. The key difference between a convertible note and a regular term loan then revolves around the expectation that the investor will be compensated with proportionate ownership in the company rather than a repayment of cash at the end of the note term. It is common for this ownership to come in the form of preferred equity or common equity.
The addition of maturity dates provides a time limit by which a conversion must occur to prevent the note from remaining outstanding in perpetuity. However, in practice it is rarely advantageous for the investor to force conversion or return of capital on the maturity date if a qualified financing has not yet occurred, which often leads to maturity amendments that amend the note to extend the maturity date. The addition of interest rates provides compensation to the investor for the lending of capital and provides an economic disincentive for founders to unnecessarily delay conversion of the notes. Interest due on convertible notes is almost always deferred so that it may be accumulated and added to the conversion amount of the note for more investor ownership.
In addition to enhanced upside, convertible notes protect investor downside as well. Whereas SAFEs are typically treated pari passu with preferred equity in the liquidation hierarchy, convertible notes are senior debt instruments that stake first claim to any assets or intellectual property. In practice, a defaulted early-stage company will rarely have significant real assets, so the latter becomes the more important consideration to investors.
While convertible notes are relatively standardized documents, the key terms that need to be agreed upon by founders and investors are as follows:
Caroline invests in GreenStuff, LLC, an early-stage venture founded by Elizabeth that is attempting to turn its nascent battery technology into a successful enterprise. After some negotiation, they agree on a convertible note with the following terms:
Seven months later, on December 1, 2021, GreenStuff issues additional convertible notes to multiple investors with a cumulative par balance of $700k. At this time, Caroline’s investment has accrued $2,932 in interest over 214 days, but Caroline has not received any cash compensation due to the deferred interest payout. This financing round does not meet the qualified financing threshold and does not trigger a conversion of the notes.
Seventeen months later, on May 1, 2023, GreenStuff has begun to experience significant traction and raises a priced preferred equity round from a venture capital fund at a post-money valuation of $5MM, which results in 1MM shares outstanding at a PPS of $5.00. Because the post-money valuation is less than the valuation cap, the discount rate (rather than the valuation cap) will apply to the preferred equity exchange of the convertible note. A 20% discount to the PPS of $5.00 results in a PPS of $4.00. Caroline’s initial investment of $50k has grown to $60k over two years using simply compounded annual interest of 10%. Caroline exchanges her $50k principal and $10k interest for 15,000 shares of preferred equity in GreenStuff and the convertible note is cancelled.
Convertible notes are the investor-friendly version of SAFEs, with the addition of features designed to enhance investor interests like maturity dates and interest rates. They are at their core simply a loan from an investor to an early-stage company. The problem is that loaning to pre-revenue and pre-profitability companies is a risky endeavor because they rarely have the cash on hand to pay back investors. The key difference between a convertible note and a regular term loan then revolves around the expectation that the investor will be compensated with proportionate ownership in the company rather than a repayment of cash at the end of the note term. It is common for this ownership to come in the form of preferred equity or common equity.
The addition of maturity dates provides a time limit by which a conversion must occur to prevent the note from remaining outstanding in perpetuity. However, in practice it is rarely advantageous for the investor to force conversion or return of capital on the maturity date if a qualified financing has not yet occurred, which often leads to maturity amendments that amend the note to extend the maturity date. The addition of interest rates provides compensation to the investor for the lending of capital and provides an economic disincentive for founders to unnecessarily delay conversion of the notes. Interest due on convertible notes is almost always deferred so that it may be accumulated and added to the conversion amount of the note for more investor ownership.
In addition to enhanced upside, convertible notes protect investor downside as well. Whereas SAFEs are typically treated pari passu with preferred equity in the liquidation hierarchy, convertible notes are senior debt instruments that stake first claim to any assets or intellectual property. In practice, a defaulted early-stage company will rarely have significant real assets, so the latter becomes the more important consideration to investors.
While convertible notes are relatively standardized documents, the key terms that need to be agreed upon by founders and investors are as follows:
Caroline invests in GreenStuff, LLC, an early-stage venture founded by Elizabeth that is attempting to turn its nascent battery technology into a successful enterprise. After some negotiation, they agree on a convertible note with the following terms:
Seven months later, on December 1, 2021, GreenStuff issues additional convertible notes to multiple investors with a cumulative par balance of $700k. At this time, Caroline’s investment has accrued $2,932 in interest over 214 days, but Caroline has not received any cash compensation due to the deferred interest payout. This financing round does not meet the qualified financing threshold and does not trigger a conversion of the notes.
Seventeen months later, on May 1, 2023, GreenStuff has begun to experience significant traction and raises a priced preferred equity round from a venture capital fund at a post-money valuation of $5MM, which results in 1MM shares outstanding at a PPS of $5.00. Because the post-money valuation is less than the valuation cap, the discount rate (rather than the valuation cap) will apply to the preferred equity exchange of the convertible note. A 20% discount to the PPS of $5.00 results in a PPS of $4.00. Caroline’s initial investment of $50k has grown to $60k over two years using simply compounded annual interest of 10%. Caroline exchanges her $50k principal and $10k interest for 15,000 shares of preferred equity in GreenStuff and the convertible note is cancelled.
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