A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round; in effect, the investor would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor would receive equity in the company.
The primary advantage of issuing convertible notes is that it does not force the issuer and investors to determine the value of the company when there really might not be much to base a valuation on – in some cases the company may just be an idea. That valuation will usually be determined during the Series A financing, when there are more data points off which to base a valuation.
Convertible Note Terms
When evaluating a convertible note, there are a few key parameters that must be kept in mind:
This represents the valuation discount you receive relative to investors in the subsequent financing round, which compensates you for the additional risk you bore by investing earlier.
The valuation cap is an additional reward for bearing risk earlier on. It effectively caps the price at which your notes will convert into equity and – in a way – provides convertible note holders with equity-like upside if the company takes off out of the gate.
Since you are lending money to a company, convertible notes will more often than not accrue interest as well. However, as opposed to being paid back in cash, this interest accrues to the principal invested, increasing the number of shares issued upon conversion.