Back to basics: what is a convertible note?

Back to basics series

One of the beauties of angel groups is that they bring together people from all different backgrounds – business-people (from large corporate, owner-operators, startup entrepreneurs), academics, doctors, young, old, native Carolinians or transplants, and more.

But sometimes we forget that new angel investors, especially those without a finance background, can find the terminology challenging. Over the next few months, we are going to post occasional “back to basics” posts on topics that should give a better grounding for those new to this asset class.

First up, what is a convertible note?

Sometimes (though rarely) we might consider investing in a convertible note.

What is a convertible note?

- debt – money loaned to a company

- like normal debt, they have an interest rate (typically 8% simple annual interest); unlike normal debt, the interest “accrues” (is added to the outstanding balance) rather than paid in cash

- unlike normal debt, the note is not to be repaid; instead it converts into equity when a new equity round is raised

- it converts at a discount to the valuation of at which the new money is raised (typically 20% discount)

- you can learn about convertible notes here (in the "term sheet" slides)

When would we invest in a convertible note?

- only if there is a “clear line of sight” to the next equity raise so that a conversion can occur

- only if there is a short duration of the note and a conversion required at the end of the period with no “repayment” option

- only if there is a "cap" on the valuation (i.e. that the note converts into equity at a maximum valuation of, for example, $5 million)

- generally in a follow-on round of an existing portfolio company, not a wholly new investment

Why don’t we invest in convertible notes generally?

There are multiple reasons to avoid convertible note. We cover these in our education materials, but essentially convertible notes rarely provide an adequate return potential for the risk of investment. You can see the ATA’s warning here, and one of many problems with convertibles (that they don't start the capital gains clock) in William Bissett's recent note.