Tech lawyers’ advice on writing convertible notes for startups

Let’s imagine you have an innovative startup idea, but you need additional financing to create an MVP and promote a product. The challenge is that it is impossible to evaluate your company at this stage, making it difficult to attract investments. In this case, startup founders often use Convertible Notes to raise money from investors. 

What's a Convertible Note?

A Convertible Note is a financial instrument used for early-stage startups, or as a bridge when a company isn’t quite ready for the next round of financing. It is a type of debt security that can be converted into equity (shares) in the company at a later date, typically when the company raises capital in a future financing round. Until that event, a convertible note is simply a loan that accumulates interest.

How does a Convertible Note work?

Convertible Notes go through several stages, from their issuance to their eventual conversion into equity or repayment. Here are the six stages in the lifecycle of a Convertible Note:

1. Issuance. This stage includes due diligence and negotiation of terms. If parties agree on the terms, they sign the Convertible Note agreement. 
2. Funding. The investor provides funds to the startup in exchange for the Convertible Note.
3. Accrual of interest. Convertible notes may accrue interest at an agreed upon rate. This interest accumulates during the time the note is outstanding and is usually added to the principal amount upon conversion.
4. Conversion trigger. The exit event or condition that results in the conversion of the note into equity.  The conversion triggers include the qualified financing round, IPO, change of company owner, or other events. For example, the convertible note automatically converts into equity when the company raises at least $1 million in a Series A financing round.
5. Conversion into equity. When the conversion trigger occurs, the convertible note turns into equity. The conversion price is usually set at a discount to the price per share offered to investors in the subsequent equity financing round. This gives convertible note investors an advantage by allowing them to convert their debt into equity at a lower price.
6. Equity ownership. The investor becomes a shareholder in the company. 

If the conversion trigger does not occur, the startup is obligated to repay funds to the investor, including accrued interest. 

The key terms of a Convertible Note

Below are the key deal points you need to know to begin negotiations with confidence.

• The principal amount specifies the amount of money the investor is lending to the startup.
• The interest rate will be accrued on the principal amount of the note over its term. That is the amount you pay the investors for using their money now to make your profit later. Usually, interest rates are between 4% and 6%. For example, if the convertible note has an interest rate of 5%, and the principal amount is $200,000, then the note accrues $10,000 in interest annually. 

The accrued interest is usually added to the principal amount of the note, increasing the total amount that could convert into equity when the conversion trigger occurs. Following our example, when the note converts into equity, the investor receives ownership shares based on the total amount, including the principal ($200,000) and the accrued interest ($10,000).

• The maturity date is the deadline when the Convertible Note must be repaid if not converted into equity. It is usually between 18 and 36 months after signing the Convertible Note.
• Conversion terms
  • The discount applies to the price per share in the next qualified financing round. Usually, the discount is between 15% and 25%. For example, the note converts at a 20% discount and the new investors are paying $1 per share. The convertible note investor will convert at $0.80 per share. This means that if the convertible note investor invested $200,000 they would receive 250,000 shares rather than the 200,000 shares they would have received if they invested in the qualified financing. 
  • The valuation cap is the maximum valuation at which the note can convert when the conversion trigger is met. It serves as a safeguard for early investors, ensuring that they benefit from a favorable valuation even if the valuation of a startup increases significantly in a subsequent financing round. 

For example, a valuation cap is $5 million. To determine the conversion price, you need to compare the valuation cap to the valuation of the financing round. If the valuation of the financing round exceeds the valuation cap, you use it as the basis for the conversion price. The formula is: сonversion price = valuation cap/number of outstanding shares at financing round. If the valuation cap is $5 million and the sum of the outstanding shares at the financing round is $8 million, the сonversion price is $0.625 per share. When you have the conversion price, you can calculate the number of shares the investor receives upon conversion. The formula is: number of shares = principal amount/conversion price.

• Conversion trigger is the event or condition that activates the conversion process.
• Events of default refer to specific conditions or circumstances that may result in a change in initial terms. For example, failure to raise additional financing or meet milestones can be considered events of default. As a result of those conditions, the investor can demand repayment of the debt ahead of schedule.
• Restrictions are clauses in Convertible Note which prohibit some startup actions during the term of the note. For example, incurring additional debt without the prior written consent of the noteholder.
• Governing law and jurisdiction clauses determine what body will resolve disputes and which law will be applied. 

Moreover, the Convertible Note can include clauses covering confidentiality, representations and warranties, and the rights and obligations of the parties.

The Convertible Note is a quick, flexible and simple instrument, which delays the valuation of the company until a future financing round, making it easier for startups to attract early-stage investors. On the other hand, the startup must repay the principal and interest if the conversion trigger is not met, which can be financially burdensome. Before using that instrument startups should assess the risks and drawbacks. Pay attention to high interest rates, low valuation caps, and large discounts. Think twice if your startup does not have a path to raising money through a financing round or achieving an exit event. 

If you decide to use a Convertible Note, make sure that all the terms in the agreement are clear. It's important for startups to carefully evaluate whether convertible notes align with their financing needs, growth plans, and overall strategy.