Early-Stage Startup Deals: How Do Convertible Notes Work?

2 5 minutes read

Early-Stage Startup Deals: How Do Convertible Notes Work?

Editor’s note: This is part two of a two-part series about financial instruments that angel investors use to more easily invest in early-stage startups. Part one is Early-Stage Startup Deals: How Does a SAFE Work?

Buying a stake in an early-stage startup isn’t easy. When a company isn’t generating revenue yet, it’s tough to agree on what it’s really worth. That’s why venture capitalists often use simpler tools — like convertible notes — that let them make deals faster and with fewer legal fees.

Convertible notes represent a debt owed by the startup to the investor. The agreement is that the investor provides a loan to the startup in exchange for a convertible note. The loan accrues interest annually and has a maturity date. When this date arrives, the startup must either repay the loan with interest or convert it into shares.

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Conversion may occur earlier if a certain event occurs. This event, as with a SAFE (simple agreement for future equity), is usually referred to as the equity financing round.

In the venture world, convertible notes are the second most commonly used type of early-stage startup agreement, following a SAFE.

Important terms of convertible notes

Convertible notes share many similarities with SAFEs: The agreement may include a valuation cap and/or discount rate, as well as conditions for a liquidity event and dissolution event. However, two key provisions distinguish convertible notes:

Maturity date. The deadline for repaying the loan and interest, typically set between 18 and 36 months.
Interest rate. The amount the startup pays the investor for using the funds. Based on my experience, this usually ranges from 4% to 10% per year.

Different types of convertible notes

There are also several types of convertible notes. The calculation of the investor’s share is done in the same way as with a SAFE, but the interest accrued on the loan is added to the investment size.

Convertible note with valuation cap. The investor can convert the note based on the valuation cap, even if the startup’s actual valuation exceeds that amount.
Convertible note with discount. The investor can convert the note at a discounted share price, meaning lower than the price paid by investors in the equity financing round.
Convertible note with valuation cap and discount. The investor can choose the more advantageous conversion option — either based on the valuation cap or at the discounted price. This type of agreement is less common, and I have not encountered it in my experience.

Similar to a SAFE, at the time of the deal, the investor cannot predict which type of convertible notes will be more beneficial for them, as it depends on various factors.

Risks and investor protection mechanisms

With convertible notes, interest on the debt and the maturity date offer appealing terms for the investor, motivating the founder to secure a strategic investor. In contrast, a SAFE does not impose such requirements. However, what should be done if the maturity date is reached and the equity financing has not occurred?

In theory, the startup is obligated to repay the debt along with interest. However, if it hasn’t secured a funding round, it likely lacks the necessary funds. To address this, the investor can include several options in the agreement:

Forced repayment. This option is seldom utilized, as it risks driving the company into bankruptcy, which is not beneficial for the investor.
Maturity extension. This approach provides the founders with additional time to raise capital, increasing the likelihood of a favorable return for the investor.
Common stock conversion. This is a viable option for the investor if the startup is experiencing growth. Common stock increases in value similarly to standard preferred stock held by investors. The conversion is executed according to a formula outlined in the agreement.

The last provision safeguards the investor, even if the startup seeks to move on without them.

Here’s a scenario: The startup is thriving but intentionally postpones the funding round. When the maturity date comes, it repays the convertible note holder’s debt with interest. Shortly after, the company raises new capital.

New investors secure a stake in the now-successful venture, while the early investor, who took on the most risk, is left behind. Mandatory conversion into common stock ensures that the investor can still retain a position in the company.

As I mentioned before, in the event of a liquidity or dissolution event, convertible note investors are entitled to receive payments before others, alongside regular creditors.

While an investment return clause is usually included in a SAFE template, it must be specifically added to convertible notes. The parties may even negotiate to increase this amount, for instance, to twice the original investment.

In investor terminology, this is referred to as a “2x liquidation preference.”

This option may seem appealing, but I recommend that inexperienced investors temper their expectations. High liquidation preference multiples can be detrimental to the startup.

Later investors will often demand the same terms, which leaves founders and employees unsure of the payouts they can expect as the last in line.

This undermines team motivation, a critical factor in any business, but even more so in startups, where it can be the difference between success and failure.

Finally, it’s important to note that if there are no funds left in the startup’s account upon dissolution, convertible note holders, just like SAFE holders, will receive nothing.

A side letter for convertible notes

A side letter for convertible notes is an agreement where the parties outline additional terms. While it’s not a required document, I strongly recommend negotiating its inclusion. Here are some provisions that might be found in a side letter:

Pro rata rights. This gives investors the option to maintain their ownership percentage in the startup. For instance, if an early investor’s stake drops from 10% to 5% after an equity financing round, they have the right to buy more shares to bring their ownership back to 10%. The shares must be purchased at the same price as those acquired by new investors, without any discounts for SAFE or convertible note holders.
Information rights. This clause ensures that early investors are kept informed about the startup’s progress, typically through quarterly and annual financial reports. The standard terms of SAFEs and convertible notes do not obligate startups to report to early investors, and as a result, they are often left in the dark.

Conclusion

Convertible notes provide more legal safeguards for investors compared to SAFEs. However, during negotiations, it’s important to keep in mind that the investor’s main objective is not to burden the startup with numerous obligations, but to offer the resources necessary for its rapid growth, benefiting both parties in the long run.

Remember, no agreement can guarantee the return of your investment. Often, the best protection comes from choosing the right startup.

While you can leave the deal structuring to lawyers, I recommend that investors personally hone the skill of selecting the right startups.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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