How Do Convertible Notes Work?


Convertible notes are debt securities that carry a convertible feature allowing investors of a convertible note to convert their debt holdings to an issuer's equity upon specified future events. Convertible notes are often used by start-ups in their early stage of financing to attract venture investors, but they also have certain attributes that are advantageous to start-ups themselves. Investors in convertible notes mostly expect to convert their promissory notes to equity when the start-up becomes successful, rather than having the notes paid back.

Convertible Notes

Convertible notes are a form of debt but also resemble equity. Like all debts, convertible notes bear interest but the interest is only accrued and payable at a future date, instead of being paid out to debt holders in regular intervals. Moreover, interest rates on convertible notes often are lower than those from standard borrowings, because investors can potentially benefit from a later equity conversion. To attract investors, issuers usually sweeten conversion terms by giving investors a discounted equity price as compared to the price for later investor in an equity issuance.

The Investors

Uncertain about a start-up's future, cautious investors may not want to go directly to equity investing. Providing capital through the purchase of convertible notes allows investors to safeguard their investments but also catch any upside if the issuing company turns out successful. If an equity conversion didn't happen, the notes would remain due. If the issuer fails to pay off the notes, investors may foreclose on the company's existing assets.

The Issuer

Convertible notes are also beneficial to issuers of start-ups, as they provide relatively affordable lending with low interest rates and no interest payments for certain periods to the often cost-sensitive start-ups. Additionally, issuing debt of convertible notes as opposed to equity at an issuer's initial financing avoids any mispricing in the company's equity valuation. For a start-up, it's often hard to place a value on it without an established equity market. Venture investors tend to value start-ups at the lower end of a valuation spectrum, which can come at a cost to start-up founders.

Equity Conversion

Convertible notes are converted to equity upon specified future events including a formal equity financing. An initial issuing of equity at a later time by a start-up indicates that the company has seen business growth and now requires more capital. An equity issuance also suggests that the company finally has a demonstrable value, which is also in the interest of its convertible-note investors. To covert to equity, investors and the issuer use the valuation established in the equity issuance to other investors, as well as the conversion discount given in the notes. For example, for a $100,000 investment in convertible notes, and with an equity price set at $10 per share and a 20 percent conversion discount, investors can expect to have their notes converted to 12,500 shares ($100,000 / $8).

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