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September 21, 2022

Convertible Promissory Notes

Convertible promissory notes are hybrid investment vehicles that combine debt and equity, and are a popular choice for founders and startups at early stages.

Convertible promissory notes are a widely utilized investment vehicle for early-stage companies at just about any time in their growth but are most commonly used for seed rounds. Especially in the last ten years or so, these vehicles have become very popular among founders and angels, in particular. Convertible notes are short-term debt instruments that the holder can convert into equity at a later date. Companies and investors like convertible notes because they are simple and quick to close, usually with minimal attorneys’ fees and compliance costs. The company avoids issuing equity for the moment while bringing in needed cash. This also allows companies to continue their growth without immediately giving away any voting rights or the need to determine a company valuation.

Fig. 1

 

Under a typical convertible promissory note, an investor will give the company a loan with repayment terms. The repayment terms include an interest rate and a maturity (due) date when both principal and interest are due. There is typically a valuation cap and a discount to determine how the note converts. Because of the discount (and assuming the valuation cap is low enough), most convertible note investor are more interested in acquiring equity when the note converts rather than getting repaid the principal and interest.

There are a few pros and cons to convertible note financing. One of the best things about convertible notes is clear and straightforward documentation leading to a quick close and receipt of funds. The downside is that the company gives equity away for a lower price if the note converts. The conversion typically occurs when the company undertakes a subsequent round of fundraising of a certain amount (or when the maturity date arrives). Companies can sometimes repay notes prior to conversion to avoid new equity on their cap table.

Fig. 2

Some of the terms you might find in convertible notes are described in Figure 2.  

 

·      The “valuation cap” puts a limit on the price per share of the converted equity.

 

·      A “discount” is given on the price of the equity into which the note converts.

 

·      Notes incur “interest” over the term of the note that increases the number of shares the into which the note converts.

 

·      Notes have a “maturity date” where the note must be paid in full, including interest earned.

 

Companies that are in high-growth mode and need cash often consider convertible notes. When a company is growing rapidly, founders often turn to investors for a convertible note round. The assumption here is that there will be another, priced round, in the future where the investor’s investment will be rewarded for an early investment.

 

Convertible notes are often compared to simple agreements for future equity (SAFEs). SAFEs are more advantageous for companies but not always acceptable to investors, who appreciate the definite maturity date of a convertible note rather than having no term at all in a SAFE. In addition, the SAFE does not offer an interest rate, which is also something investors like, given the accumulated interest will often also convert into shares under a convertible note.

To explore how your company might use convertible notes to raise private capital, please contact us at info@afissio.com.

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