What is a Convertible Note?

Convertible notes explained

If you're starting your first company, understanding stock, preferred stock, options, convertible notes and other fundraising instruments can be truly overwhelming.

If you are an early-stage startup in the tech space and you are looking for money to grow your company, the official term is raising capital, the most commonly recommended instrument to raise funds is a convertible note. However, to understand how those work, we first need to understand how equity (or stock) works.

Note: If you understand what a stock is, skip to the What is a Convertible note section‍

What is a Stock?

You are probably semi-familiar with the term 'stock.' A Stock is what represents the company ownership and it is distributed in parts to reflect how much of the company each owner possesses.  Each owner, or shareholder, receives a certain number of shares of stock.

The number of shares a person or entity owns in the company, divided by the total number of shares that have been issued, reflects that person’s percentage ownership of the company.

That ownership of the company is often acquired with a cash investment, but it can also be acquired through other forms of value contributed, like your hard work. The percentage owned normally determines a shareholders’ claim on the company distributed profits (the term used is dividends) and the voting power on certain key company decisions.

Let’s an example we'll call... Slidebean.

Let's say that Slidebean has two founders, who came up with the concept together, and have both committed all of their professional time to develop this business, so they'll be equal partners.

So Walter and Jesse Incorporate Slidebean. Startups are usually incorporated with about 1,000,000 shares of stock. Why so many? Because it’s complicated to break a share in half. We’ll get to that in a minute.

So each one of the founders owns 500,000 shares, which represents 50% of the 1,000,000 total. Most startups are Delaware C-Corporations, they just are, because it's the legal structure most familiar with investors, it is easy to set up, easy to manage and tax friendly.

A priced round: Raising money for stock

The 'traditional' approach towards raising capital is with what is called a “priced round”, meaning, a round in which both the founders and the investor are able to agree on an accurate valuation for the company, and so the investor gets shares of company stock.

Let's say that Slidebean starts operating and sales are going very well. They're selling $10,000/mo, and subscriptions are growing fast, so they decide to raise money. They calculate a nice round number of, say,  $500,000 in investment that they need to raise to accelerate their business, so they seek out an investor. Remember, companies rarely raise money without traction; we made a whole video about that. Check it out.

So, how many shares do they offer an investor in exchange for $500,000? That question relates to the business valuation. How much is the business worth?

If Walter and Jesse owned a car wash instead of Slidebean, its value would be calculated using a multiplier of their revenue or profits (really, their EBITDA, but who has time to explain that). If Walter and Jesse are making $10,000/month, or $120,000/year, a traditional business could be worth maybe 1x or 2x this, depending on how profitable they are.

This means that an investor could literally buy the whole business for $250,000 or so (excluding the value of the land or the building).

However, tech startups are different. Tech startups could have tremendous scale potential and fantastic margins, so it’s extremely hard to measure how large and fast they can grow in revenues and in value.

A software product or an app, for example, can realistically serve millions of customers around the world, with a minimal staff. Think of Uber, who raised $500,000 on their first round, and are now worth, well, close to $80B of dollars. They did not need to invest billions of dollars on buying a car fleet, for example.

So the value of a startup is not related directly to their current assets or revenues, but to their upside potential, their capacity to innovate and transform those innovations into value. Some variables to take into account here are:

• The addressable market size, how many customers are there for the company to serve and how much would they be willing to pay for what you offer.
• The technology variable, is there a unique piece of tech that nobody else has, or that optimizes a process drastically?
• Potential margins, how much does it cost me to serve an additional customer? When Instagram had 300 million users, their staff was only 13 people.

However, all these numbers are variables and estimates, and nobody knows for sure. But based on them, along with some credible early results, the startup valuation is defined by how much potential an investor sees in the business, how risky it is, and how much upside do they expect in exchange for risking their money, just like a bet.

Try Slidebean

These days, an average valuation in Silicon Valley, for a tech company like our theoretical Slidebean would be a $4,000,000 pre-money valuation. Again, assuming this is a high-scale, high-margin business, not the car wash.

Related read: How to value your Startup

If Gus, our investor, accepts these terms, then he would be purchasing a $500,000 chunk of this business. Simple math tells us that if the full company is worth $4,000,000, then $500,000 would represent about 11% of this. Let's dig deeper:

Remember Walter and Jesse both have 500,000 shares of this business. Typically, the original shareholders  do not transfer or sell their shares, what's going to happen is the company will issue new shares to Gus. In businesses stock rarely changes owner, unless the business is sold. On the contrary, companies often issue new stock, which dilutes the original shareholders percentage ownership.

In the simplest form, if Walter and Jesse had one share each, they would own 50% of a 2-share business. If the company issues a new share of stock to Gus, then everybody still holds one share, but it's no longer 50% of the business, but 33% of it.

In this case for the math to work, Slidebean will issue 125,000 new shares of stock to Gus. When the company does this, it will no longer have 1,000,000 shares, but 1,125,000 shares.

Walter and Jesse will still have 500,000 shares each, but they no longer represent 50% of the business, but 44.4%. The new 125,000 issued to Gus now represent 11.11% of the company. The post-money valuation of Slidebean is now $4,500,000.

This is why we had 1,000,000 shares to start with, so that we don’t have fractions of shares. If the company would have been incorporated with only 100 shares, for example; 50 for Walter and 50 for Jesse... then it would have had to issue 12 or 13 stocks to Gus, so we’d need to round up or down.

This may be worthless now, but a 0.01% equity stake in a company like Uber is worth about $8 million today.

Now, the challenge with raising money this way, a priced round, is that there are a lot of things to figure out, for example,

• How many votes does each share get in certain decisions? Usually, you get one vote per share, but investors will often want more control over certain decisions since they have minority ownership.
• If the company goes bankrupt and needs to liquidate assets, do investors get paid first?
• How does the Board of Directors look? Investors will also want to control a seat and to protect themselves against being removed from the Board.

All of these decisions require negotiations, and lawyers, and signatures to be put in writing, and they can make the process take six months or more from the verbal 'agreeing to invest.' Since most early companies don't have six months, they often choose to go with a Convertible Note.

What is a Convertible note?

A convertible note is an instrument that delays the valuation conversation, and it allows the company and the investor to reasonably agree to go forward to the investment much faster, with less negotiation, and complicated and costly legal processes.

A convertible note is like a loan, but instead of using an asset like a house for collateral, the company stock is the collateral at a valuation for the company that would be decided in the future. This means, obviously, that the investor also needs to believe in the business to invest, because it is the intention of the investor to convert its note into stock.

Like I said before, defining a company valuation is tough. Too many uncertain variables, too little data... so with a convertible note, the investor is saying: I'll give you the money for you to grow now. In a year or so we should have the data to support a priced, traditional funding round, so my investment will convert then, using a formula that would be based on the valuation and terms that the company and the investors define for such future priced round.

Convertible notes have some terms that can be hard to grasp, so we’ll talk about them through examples.

Convertible Note Scenario A

A) Walter and Jesse take the money from their first investor, Gus, on a convertible note. With the money they grow as expected, their business looks very healthy and promising and one year later they manage to attract a new investor, Madrigal, who is willing to invest $1,000,000 on a priced round that values the company at $5,000,000.

When this new investment comes in, the convertible note is triggered. To compensate Gus for believing in this company early on, notes have an interest rate, and a discount. The interest is usually 5%-6%, and the discount is 10-25%. That is a discount on the valuation set by the new investor.

In this case, again, Gus invested 1 year before Madrigal’s round, so he’s earned about $25,000 in interest. When the day comes, Gus converts $525,000 at a $4,000,000 instead of the $5MM valuation that Madrigal got (that’s the 20% discount).

Madrigal then invests their $1,000,000 at the $5,000,000 million valuation.

Convertible Note Scenario B

B) Let's look at another scenario where the company grows tremendously fast. In a couple of years, Slidebean finds a new investor that values the company at $50,000,000.

Even with the 20% discount, Gus’ valuation to convert is $40,000,000 so his original $500,000 investment would translate to less than 1.5% of the company. The risk/upside tradeoff that was taken by Gus was not fairly compensated in this investment in Slidebean.

This is why notes have a Valuation Cap. A Cap is a maximum valuation at which the note will convert.

Let’s say the Cap in this case was $7MM. So, what would happen is that, while the new investors will invest in the company valuing it at $50,000,000, Gus will convert his note at the Cap, resulting in a ~6x paper return on Gus’ investment. Not bad at all…

The same mechanism would apply if the company is acquired, by the way. The convertible notes would trigger their conversion in order to participate in the sale of the company.

Convertible Note Scenario C

C) Let's look at a third scenario, the one that is less frequently discussed: what if the company doesn't grow? If the company can't raise additional round of funding in the future because they didn't manage to show traction and therefore couldn’t attract new investors, then in this case, at the maturity date, the Convertible Note owners can convert their notes and interest at the Valuation Cap or request a payback.

Now, investors will probably request a convertible note payback only if the company can afford it. And, maybe they believe that converting at the Cap is too expensive a valuation for the company at the time.

If the company can't afford it and the investors execute the notes, the startup will probably need to file for bankruptcy. They'll also lose all (or most of) their money, since the company doesn’t have the assets to pay the notes.

Using the same $500,000 example, maybe Walter and Jesse couldn't find a good product-market fit, but they are still making say, $500,000/year in revenue. What happens in these cases is that the company and the convertible note investors agree to one of the following:

i) extend the maturity date on the notes and continue accumulating interest. This gives the startup time and a chance to accelerate growth and be able to attract a new round of financing, or,

ii) enter into a repayment schedule, in which the company will pay the notes over a predefined period of time and in multiple installments, instead of repaying it all at once at the maturity date.

So summarizing a convertible note is an investment with an interest rate, a cap and a discount. The note is triggered or executed,

• Ideally, on a new round of funding.
• Also ideally, if the company is acquired.
• Otherwise, at a predefined deadline or maturity date often 18 or 24 months after the original investment. At this point, investors can negotiate a note extension, they can convert it at the Cap, or they can request a payback, again, if the company can afford it.

SAFE vs Convertible note

Now, YCombinator and 500 Startups have both designed documents inspired by convertible notes, but even simpler to execute (meaning, even faster to get the money from investors). And free.

The KISS-A (Keep it simple security) and the SAFE (simple agreement for future equity) are simplified convertible note templates that you can use to raise money and skip lawyer fees. They both work as a convertible note but reducing a lot of the paperwork requirements.
The terminology is the same that we’ve already discussed, so by now you should have no problem understanding what those mean.  You can download it on our Slidebean site, and refer to the knowledge base for more details on completing it.