While convertible preferred stock is the most common venture financing tool for more mature startup companies, at the seed stage, the most frequently used instrument for raising modest amounts of capital is the convertible promissory note. Convertible promissory notes (or convertible notes, as they are more commonly called) are debt securities that provide flexibility and protection for both investors and startups. This article explores the key terms, conversion events, and pricing mechanisms associated with convertible notes.
KEY TERMS OF CONVERTIBLE NOTES
Convertible notes are structured as debt instruments with the following essential terms:
Principal Amounts and Maturity Date: The principal amount of the convertible note is the initial sum of money invested, which is due for repayment on a specified maturity date. This date typically ranges from 12 to 24 months from the issuance of the note.
Interest Rate: Convertible notes accrue interest on the principal balance at a fixed rate. This interest is usually simple interest, meaning it accrues based on the principal balance without compounding.
Conversion to Preferred Equity: The primary feature of convertible notes is their potential to convert into preferred equity securities during specific conversion events. This feature aligns the interests of the noteholders with those of future equity investors.
Seniority: Convertible notes have a claim on the company’s assets that is senior to all equity holders and typically pari passu (on equal footing) with all other unsecured non-senior debt. This seniority provides some security for investors in the event of liquidation.
Although convertible notes are formally debt instruments, many investors view them as deferred or unpriced equity. The goal of their investment is to convert the notes into the same preferred equity security that the company issues to its first or next institutional VC investor in a preferred equity round.
CONVERSION EVENTS
Convertible notes convert into equity when specific events occur. These conversion events are critical for investors, as they determine the timing and conditions under which their debt investment transforms into an equity stake.
Next Equity Financing Conversion: The most common trigger for note conversion is a subsequent preferred stock financing, referred to as a Next Equity Financing. In this scenario, the principal and interest of each note convert (at the relevant conversion price) into shares of the same series of preferred stock that the new equity investor purchases in the subsequent financing round.
Corporate Transaction Conversion: If the company is sold while the notes are still outstanding, noteholders may:
Maturity Conversion: If the company reaches the maturity date without triggering a Next Equity Financing conversion or Corporate Transaction conversion, convertible notes often give investors the option to:
Investors rarely choose to convert to common stock because continuing to hold debt while leaving open the possibility of receiving preferred stock in a post-maturity Next Equity Financing is generally seen as more attractive than holding common stock alongside the founders.
CONVERSION PRICE
When a conversion event occurs, convertible noteholders receive equity based on the principal and interest balance of their promissory notes but at a price that is lower than the price paid by the new equity investors. This lower price is calculated based on either a discount rate or a valuation cap.
Discount Rate: When notes convert at the Next Equity Financing (usually the company’s Series A round), they convert at a per share price that is less than the per share price of the preferred stock the company issues to its new investors in the equity financing. The rationale for giving this discount is that the startup has typically “de-risked” to some extent since the noteholders made their original investment and, therefore, they should be compensated for having shouldered additional risk early on.
Valuation Cap: Most convertible notes also contain a ceiling, or cap, on the pre-money valuation at which the notes may convert in a Next Equity Financing to protect the noteholders against runaway valuations. When notes contain both a discount and a valuation cap, the price at which the notes convert is the lesser of:
CONVERTIBLE NOTES AS BRIDGE FINANCING
Convertible notes are also used by more developed startups as bridge financing to a later-stage equity round or a sale of the company. This interim financing helps startups extend their runway, allowing them to achieve additional milestones before raising a larger equity round or pursuing an exit strategy.
CONCLUSION
Navigating the startup lifecycle requires a clear understanding of each stage’s unique challenges and opportunities. From the initial idea to maturity and exit, each phase presents different financing needs and options. At GNS Law, we specialize in guiding startups and their investors through these critical stages, ensuring they have the right financial strategies in place to support growth and success.
At GNS Law, we represent US and LATAM venture capital funds, private equity funds, and startups. For more information, contact us at info@gnslawpllc.com.
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