Convertible Note: What It Is, How It Works & vs. SAFE 2024

A convertible note is a type of short-term debt that has the potential to convert into equity, usually during a future financing round. It offers seed investors in startups a means to fund companies while deferring valuation.

What is a Convertible Note?

A convertible note is a short-term debt instrument commonly used in private markets, which startups utilize to raise capital. It operates as a short-term loan with the potential to transition into equity under predetermined conditions. Startups issue these notes to investors, who lend money with the anticipation of potentially converting them into ownership shares in the company.

Convertible note possesses several features, including issuance terms, conversion mechanisms, and maturity dates. When a startup issues a convertible note, it outlines key details such as:

interest rate,
maturity date, and
conversion terms.

Investors who purchase these notes are granted the option to convert their debt into equity under specific conditions, typically triggered by events like a subsequent financing round. This conversion typically occurs at a discount relative to the valuation of the later financing round, encouraging investors to contribute early in the startup’s growth journey.

Convertible notes offer advantages for both startups and investors. For startups, they provide a swift and uncomplicated means of raising capital without the immediate need to establish the company’s valuation. This flexibility proves especially beneficial in the early stages when valuations are unpredictable. Investors are drawn to convertible notes due to the opportunity they present for equity ownership at a discounted rate compared to later investors. However, there are risks involved, like the possibility of the company failing or not reaching a value that makes converting the investment beneficial.

Key Takeaways

Convertible notes are short-term loans commonly used by startups to raise capital, which can convert into equity under specific conditions during a future financing round.
Convertible notes outline interest rates, maturity dates, and conversion terms. Investors lend with the potential to convert debt into company shares.
Convertible notes allow startups to raise capital without immediate valuation concerns, offering investors potential equity at a discounted rate compared to later investors.

How Convertible Notes Work

When an investor chooses a convertible note for investing in a startup, they lend money to that business with the expectation of repayment with interest. Rather than receiving cash repayment, the loan is converted into equity in the company. This conversion typically occurs during a later funding round, known as a qualified financing round, with terms specified in the convertible note agreement.

Convertible note essentially comprises two key aspects:

Conversion process: Conversion typically happens when a startup raises a certain amount of capital in a qualified financing event. The convertible note sets the minimum capital needed for conversion. When triggered, the loan amount plus interest turns into equity at a predetermined rate, often at a discount compared to the investor’s share price in the funding round.
Valuation cap: Convertible notes use a valuation cap to protect investors if a startup’s value increases before conversion. This cap sets the highest valuation for conversion, regardless of the actual startup value. If the startup’s value exceeds the cap during conversion, investors get more shares, as the conversion rate is based on the cap, not the actual value.

Overall, convertible notes give early-stage companies flexibility in funding and safeguard investors from sudden valuation increases by using tools like conversion rates and valuation caps, ensuring fairness in the investment process for both parties.

SAFE vs. Convertible Note

SAFE notes, or Simple Agreements for Future Equity, have gained popularity due to their straightforward nature. Investors provide funds to startups in exchange for a promise of future equity in a SAFE note. These agreements convert into equity when specific events, such as an IPO or a priced funding round, occur. The crucial aspect is that the startup does not immediately issue shares or equity to the investor. Instead, the investor receives a document granting them the right to receive equity in the future. SAFE notes resemble convertible notes, although there are some differences.

Aspect	Convertible note	SAFE note
Type	Debt instrument	Not a debt instrument, but an agreement for future equity.
Investor Protection	Provide more protection as a debt instrument.	Less protection since it is not a debt instrument. SAFE relies on potential equity conversion.
Tax Implications	Treated as a debt for tax purposes; interest may be deductible.	Generally, no tax implications until conversion to equity occurs.
Valuation Cap	Convertible notes typically feature a fixed valuation cap or conversion price to determine how equity converts during the next qualified financing round.	Typically, SAFE notes don't have a set value upfront; the value is determined later during the next qualified equity financing round, at which point they convert into equity on the same terms as new investors.
Discount Rate	Convertible notes might offer a discount for converting into company ownership, allowing conversion at a lower price per share compared to new investors in future funding rounds.	SAFE notes may not have a discount rate.
Interest Rate	Interest may accumulate annually during the term of the note and is payable upon conversion or maturity, increasing the principal amount.	SAFE notes typically don't earn interest because they're not convertible debt instruments.
Maturity Date	Convertible notes must be repaid or converted into equity by a set maturity date. If a qualified financing round isn't raised by this date, repayment of the principal and interest may be demanded.	SAFE notes don't have a set repayment date. Startups aren't required to pay back the invested amount if they don't go through a specific funding round. The investment either turns into equity or stays as is until it's converted or repaid in another way.
Conversion Triggers	Convertible notes convert to equity upon specific events like future financing, reaching a capital threshold, or other triggers such as a change of control or IPO.	SAFE notes convert to equity upon the occurrence of a future equity financing round.

Convertible Note Advantages

Convertible notes let investors invest early in startups, converting their debt to ownership later with good terms, offering flexibility and potential for higher returns. For startups, they offer quick access to capital without immediate dilution, making fundraising simpler and encouraging future equity financing for growth.

Advantages	Investors	Fundraisers
Early Investment Opportunity	Gain access to early-stage startups.	Secure early-stage funding without establishing valuation.
Flexibility in Terms	Tailor terms to preferences and risk appetite.	Negotiate terms more favorable than equity financing.
Deferred Valuation	Postpone complex valuation negotiations.	Maintain greater ownership and control during the early stages.
Interest Accrual	Interest grows with time, leading to higher returns.	Provide potential additional returns upon conversion.
Conversion Premiums	Benefit from conversion discounts or valuation caps.	Potentially enhance returns in subsequent financing rounds.
Quick and Simple Financing	Expedite fundraising process.	Focus on business growth rather than valuation negotiations.
Preservation of Ownership	Retain ownership and control during the early stages.	Maintain a greater equity stake in the company.
Incentive Alignment	Negotiate terms without setting an initial valuation.	Customize terms to suit the company’s needs.
Bridge to Equity Financing	Serve as a bridge to future equity financing rounds.	Obtain capital to reach key milestones before equity financing rounds.

Convertible Note Disadvantages

Convertible notes present challenges for both investors and fundraisers, including lack of control, potential dilution, uncertain valuation, and complex terms, which require careful consideration. Despite providing quick access to capital for fundraisers and postponing valuation until a later equity round, they can also lead to dilution risks, debt obligations, and strained investor relationships.

Disadvantages	Investors	Fundraisers
Uncertain Valuation	Investors don't know the exact value of their investment until conversion.	Lack of clarity on the company’s true valuation until conversion occurs.
Limited Control	Investors typically lack voting rights or significant influence until conversion.	Potential loss of control over ownership structure.
Risk of Dilution	Convertible notes may lead to dilution if subsequent rounds occur at lower valuations.	Future dilution of ownership when notes convert into equity.
Lack of Interest Payments	Investors miss out on potential income from interest payments.	No interest payments, potentially making the fundraising less attractive.
Potential for Default	Risk of losing investment if conversion conditions aren't met.	Complex legal documentation and risk of investor dissatisfaction.

Do convertible notes need to be paid back?

Convertible notes do not require immediate repayment like a loan. Instead, they can turn into ownership shares in the company at a later time. If the company does well, the investor gets a stake in it; if not, they may have the option to get their money back. It is a way for startups to raise money without setting a fixed value for their company right away.

There are two possible scenarios:

Conversion into company’s ownership: When a convertible note converts into equity, investors receive shares of the company’s stock at a predetermined conversion rate. This conversion usually occurs when the company raises a certain amount of funding in a subsequent financing round, such as a Series A or Series B round.
Investors can opt for either equity or repayment of principal: In cases where the company does not raise additional funding or reach a specific milestone within the timeframe specified in the convertible note agreement, the note may mature, and investors may have the option to convert the outstanding principal and any accrued interest into equity or demand repayment of the principal amount.

Is a convertible note risky?

Convertible notes combine elements of debt and equity financing, creating risks for both fundraisers and investors. When a startup fails to achieve a favorable valuation, it may face difficulties repaying the notes, potentially leading to financial strain or bankruptcy. Low initial valuations result in early equity dilution, which may contradict with founders’ desires for control. Having third-party control on the valuation can introduce complexities and conflicts.

Investors face risks of equity dilution upon conversion and the possibility of repayment failure leading to bankruptcy. Conflicts may arise if conversion terms do not favor all parties.

Why do companies issue convertible notes?

Startups often choose convertible notes for favorable investor terms, bridging funding gaps between rounds. Simpler than equity, these debt instruments align interests with investors and delay valuations, ideal for early-stage companies unsure of their worth. Investors are enticed by the chance to convert to equity, indicating a commitment to the startup’s success. These notes provide short-term funding without immediate equity dilution, appealing to founders and early supporters. Overall, convertible notes offer startups a flexible funding option, while postponing valuation worries.