What is a Convertible Note?

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Contributor, Benzinga
February 17, 2022

If you're exploring the world of startup investing, you're likely wondering what a convertible note is and if they're a good investment. Keep reading to find out all you need to know about convertible notes.

Investing in startups has become a popular way for venture capitalists and wise investors to build wealth. The reason for this is simple; whenever you see a startup have an initial public offering (IPO) on Wall Street or the Nasdaq, the investors who backed that company at the startup stage make millions of dollars.  

With that said, startup investing isn’t easy and carries risk. Because startups have no track record of success and few tangible assets to pledge as collateral, securing traditional financing (bank loans) can be difficult. That’s why many companies raising money in the startup stage use convertible notes instead of bank loans to secure financing.  

What is a Convertible Note?

A convertible note is a financing arrangement that startups issue to raise money from investors. As opposed to a loan, which pays investors back via interest, convertible notes are “converted” into equity in the startup if the startup hits certain pre-arranged benchmarks that are laid out in the convertible note itself. Most often, this benchmark is the date that the startup has progressed to a point where it can be publicly traded or the startup itself can be properly valued for future investors. 

Why Startups Issue Convertible Notes Instead of Stock

Startups issue convertible notes instead of stock for several reasons. By definition, a startup is a new company with no history of performance or success. That makes it difficult for the company to meet the requirements set by the U.S. Securities and Exchange Commission (SEC) to qualify as a publicly traded stock. So most startups simply can’t use stock sales as fundraising. 

Additionally, startups are working towards a point where they can be publicly traded. Once that happens, investment banks and analysts all over the country will review the startup’s books as part of their due diligence. The less debt the startup is carrying on its books, the more attractive it will look for investors.

So, if a startup has to rely heavily on loans to grow itself, the debt created by those loans will have a negative impact on the startup’s stock price or valuation in the long term. By contrast, convertible notes give startups the best of both worlds; they allow the startup to raise money without creating excessive debt. 

Important Data Recorded in a Convertible Note

A convertible note can be structured in several ways. However, they all include a combination of the following information:

  • Discount rate: Some convertible notes offer the holders a discount rate on their shares when the note reaches its benchmarks. This discount rate entitles the holder to convert their shares to equity and purchase shares at a discount on the retail stock price. So, if the note has a discount rate of 35% and the stock is selling for $10.00 per share on the market, convertible note holders will have their equity converted to stock at $6.50 per share.
  • Valuation cap: Valuation caps place a ceiling on the amount that investors pay for equity in the startup in future rounds of fundraising. So, for example, if a startup gets to a point where it’s valued at $20,000,000 but offered convertible notes to investors with valuation caps of $1,000,000, a convertible note of $200,000 would leave the investor with 20% equity in the company as opposed to just the 1% equity $200,000 would normally buy. Investors prefer convertible notes with lower valuation caps.
  • Maturity date: This is the date at which investors can call in the amount of their convertible note, regardless of whether or not the company has hit its benchmarks. 
  • Interest rate: Convertible notes are basically loans, so in addition to the equity convertible note holders receive, they also collect interest on their loans, which will be added to the equity. 

Benefits for Investors of Convertible Notes

The first and most obvious potential benefit for investors in using convertible notes is the upside. Anytime an investor’s convertible note hits its benchmark, the investor has leveraged a relatively small amount of capital to buy an equity share in a rapidly growing company. Because startups that issue convertible notes don’t have a valuation, investors are able to get in on the ground floor of startups in a way that very few other investment opportunities offer. 

Secondly, investors are 100% sure they can convert their investment into equity (stock). By contrast, lending money to a startup would only entitle an investor to receiving a loan amount plus interest. Loan interest is a nice way to generate passive income, but it doesn’t generally offer the kind of payoff that actual equity does.  

Convertible notes are specific, while also being relatively easy for investors to manage. They have all the benchmarks and benefits laid out in a clear, easy-to-understand contract. Investors know exactly what they will be getting in return for their investment if the startups hit the benchmarks in the note, which makes convertible notes relatively low maintenance. Investors who hold convertible notes generally don’t have to be involved in the day-to-day operations of the startup, but they can still benefit from being equity shareholders if the startup is successful.

For all these reasons, convertible notes are attractive to certain investors. 

Benzinga’s Best Startup Investments

Startup investing can yield tremendous benefits to wise investors who choose the right companies. In the past, it was difficult for retail investors or people who weren’t closely connected to venture capitalists to find startup opportunities. However, thanks to the internet and loosening of federal investor accreditation requirements, you can tap into a large variety of investing platforms with startup offerings. 

If you’re interested in startup investments, take a look at this list of Benzinga’s best startup offerings below:

Are Convertible Notes Right for You?

Convertible notes offer investors the chance to use relatively small sums of money to gain large shares of equity in hot startups. As opposed to a straight loan, which limits investor profits to interest, you face potentially no ceiling on convertible notes. Think of the investors who bought convertible notes in companies like Meta Platforms Inc. (NASDAQ: FB) and Amazon.com Inc. (NASDAQ: AMZN). 

To purchase equity in those companies comparable to that of the investors with convertible notes would cost you tens, if not hundreds of millions of dollars. With that said, convertible notes are not “can’t miss” opportunities. Remember, a convertible note is still a loan: a loan to a startup with no current valuation or history of success. 

In these investments, you face the possibility of loss. That’s why the potential payoff for convertible notes is so high. The question of whether convertible notes are right for you will boil down to a number of different factors. How much can you afford to invest? How much can you afford to lose? How long can you wait for a return on your investment? Is the upside worth it? 

If you take this approach to analyzing convertible notes before investing, you could add rocket fuel to your portfolio and grow wealth faster than you ever imagined. As always, Benzinga is here to help walk you through it all with simple, easy to understand answers to your investing questions. 

FAQs

Q

What are the Key Terms of a Convertible Note?

A

Convertible notes are financing arrangements that are issued by startups. The difference is that instead of loan interest, startups pay convertible noteholders in equity when (and if) the startups hit certain financial benchmarks. That benchmark is usually when the startup meets federal requirements to be publicly traded or properly valued according to generally accepted accounting principles.

Convertible notes can be structured in several different ways, but they usually have the following key terms:

  • Maturity date: The date at which noteholders can call in their loan, regardless of whether or not the startup has hit its benchmarks.
  • Interest rate: This refers to the annual interest on the loan amount in the convertible note. The interest in a convertible note is usually converted into additional equity for the noteholder as opposed to being paid back in installments.
  • Discount rate: Usually, convertible notes give their holders preferred equity in the startup, which allows them to buy stock at a discount. The percentage of this discount off of the retail share price in the company is the discount rate.
  • Valuation cap: This predetermined ceiling shows how much noteholders will pay for their equity shares in the company. The lower the valuation cap in a convertible note, the more equity investors will get in exchange for their original investment.

Q

What is the Difference Between a SAFE and a Convertible Note?

A

Simple agreements for future equity (SAFEs) and convertible notes both create equity for investors in exchange for startup seed funding. However, unlike convertible notes, SAFE investors get equity shares in the startup in exchange for their money. This arrangement differs from a convertible note, which is a financing arrangement where investor contributions only convert to equity if and when the startup hits certain financial benchmarks.

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