Convertible notes: a founder's guide to fast startup funding

What are convertible promissory notes, how they work, and why startups use them

Contributors

Cal Davidson

Director of Partnerships

Jason Atkins

Co-founder & President

What is a convertible note?

Convertible notes, also known as convertible promissory notes or convertible debt, are a type of debt instrument commonly used by startups to secure financing during their early stages. They represent a loan that can be converted into equity at a later stage, usually during a subsequent financing round or an exit event.

Investors lend money to startups with the expectation that it will be repaid or converted into ownership in the company.

How convertible notes work?

When a startup issues a convertible note, the investor provides funding in exchange for a promissory note, which outlines the terms of the investment. The note typically includes details such as the principal amount, interest rate, maturity date, conversion terms, and other relevant provisions.

1. An investor lends money to a startup in exchange for a convertible note. This is a convertible debt that the startup agrees to repay, usually within 2-5 years.
2. Before the note comes due, the investor has the option to convert the debt into equity shares in the company, like stock.
3. If the investor converts the debt, they essentially trade in the money owed to them for shares in the company.
4. If the note is not converted, the startup has to repay the investor the full amount of the note plus any interest.

Benefits of using convertible notes

For investors

• Flexible terms. Convertible notes offer flexible terms for both the investor and the startup founder.
• Lower valuation risk. By using a convertible note, investors can avoid the risk of valuing the startup too early.
• Delayed dilution. By using a convertible note, investors can delay the dilution of their equity until a later date when the company has a higher valuation.

For startups

• Access to funds, fast. Convertible notes are often easier to obtain than equity funding.
• Lower legal fees. Because convertible notes are less complicated than equity funding rounds, the legal fees associated with them are typically lower.
• Delayed valuation. By using a convertible note, early stage startup founders can delay the valuation of their company until a later date.

Convertible note examples

Airbnb

Raised $600,000 in 2009 through a convertible note from Y Combinator and Sequoia Capital.

Dropbox

Raised $1.2 million in 2007 through a convertible note from Sequoia Capital.

Uber

Raised $1.6 million through a convertible note in 2010.

Key terms in a convertible note agreement

Conversion discount

The conversion discount refers to the discounted price at which convertible note holders can convert their notes to equity shares.

Valuation cap

The valuation cap puts an upper limit on the valuation used to determine the conversion price for the notes.

Interest rate

The interest rate is the percentage charged for borrowing money, typically around 5-8% per year.

Maturity date

The maturity date is when the convertible note debt comes due.

Conversion price

The conversion price is the price per share you pay to convert your convertible notes into equity shares.

Next equity financing round

The next equity financing round refers to the startup’s next sale of preferred stock to raise funds.

How to issue convertible note agreement?

1. Determine the terms

Decide on the key terms of the convertible note, such as conversion discount, valuation cap, interest rate, and maturity date.

2. Prepare the convertible note agreement

Draft a comprehensive legal document outlining the terms and conditions of the convertible note.

3. Execute the convertible note agreement

Conduct due diligence on the investor(s) before issuing the convertible notes.

4. Collect the funds

Ensure a secure and traceable method for receiving the investment amount.

5. Documentation & communication

Maintain accurate records of the convertible notes, including interest accrued and conversion terms.

6. Conversion or repayment

As the maturity date approaches, the convertible note will either convert into equity based on the predetermined conversion terms or be repaid to the investor with the agreed-upon interest.

Ideal scenarios for convertible notes

Early-stage funding (Pre-seed and Seed)

Bridge financing between rounds

When speed matters

Smaller funding amounts

Valuation disagreements

When to consider alternatives

Convertible notes might not be the best choice if you're raising a large Series A or later round, already have a clear, defensible valuation, or want to establish formal governance.

FAQs about convertible notes

When do convertible notes convert into equity?

Convertible notes typically convert when the startup raises its next round of funding, like a Series A.

Do convertible notes accrue interest?

Most convertible notes do accrue simple interest, often between 5 to 8% per year.

What happens if the notes don’t convert?

The notes typically become due when the maturity date arrives, requiring repayment of the principal plus any accrued interest.

Can convertible notes be converted before the next funding round?

Yes, usually convertible notes contain provisions allowing early conversion.

Do convertible notes have voting rights?

Convertible note holders typically do not have voting rights before the notes convert into equity.