If you’re already familiar with the terms and mechanics associated with convertible notes, skip to Part 1 of our series on The Case Against Convertible Notes. For those of you new to convertible notes, here are the basic terms you’ll want to understand:
First, the fundamentals:
A convertible note does not (yet) represent ownership (equity), in the company using it to raise capital. It is a form of debt, which means the investor (noteholder), is a creditor to the business, rather than an owner. Creditors have senior claims on the assets of the business over equity holders, but in exchange for taking less risk, debt holders typically receive lower returns.
Although the note does not initially represent ownership in the company, it is designed to convert into equity at some point in the future, hence the “convertible” portion of the name. The specific language in the convertible note document dictates the conditions under which the conversion can or will happen, but typically the intent is for the note to convert into equity when the next substantial equity round is raised. (Usually the note will define a minimum threshold size of a future “qualifying” equity round that will automatically trigger conversion).
Now for the “Term Sheet” terms:
The legal language in the convertible note document will specify certain terms and conditions that govern the debt instrument. Of course, the terms are negotiable, and this is not an exhaustive list, but we will cover the most impactful terms. We provide a simple illustration of the math behind these terms at this link.
Like most loans, there will be a date by which the note must be paid off or converted into equity – otherwise the noteholders may declare the note in default and begin the process to claim assets to satisfy the outstanding principal and interest. Usually this date is anywhere from 6 months to 3 years in the future, depending on circumstances.
Again, like most loans, the convertible note will carry an interest rate at which the principal earns a stated return – often in the 5%-15% range. Typically this is simple interest and it is accrued rather than paid out in cash. The accrued interest will usually convert into equity along with the note principal when there is a conversion event.
The discount term acknowledges that the noteholders are taking on more risk than the future equity investors since the noteholders are investing earlier and with less information. Because of that additional risk, the noteholders are typically entitled to convert their notes into equity at a lower price than the price paid by investors in the new equity round. The standard discount tends to be 20%, but it is negotiable and may range from 5% to 30% depending on circumstances.
Convertible notes don’t always include this term (but they should). The valuation cap establishes the maximum conversion price noteholders would pay when the note converts to equity. In other words, the note will convert at the lower of the price calculated based on the conversion discount or based on the valuation cap. We provide an illustration here.
Typically, the note specifies that the principal and interest will automatically convert into the new equity round, provided that the new round meets a minimum “qualifying” size threshold. This helps ensure the note will only convert when the company demonstrates enough progress to raise a substantial equity round that is sufficient to provide ample runway for the company’s next phase of growth.
Sometimes convertible notes will preemptively contemplate the details and price for a future optional conversion in the event the automatic conversion condition is not met. For instance, if the company is unable to raise an equity round prior to note maturity, the notes could convert at a pre-determined price based on revenues or a prior round (or any other negotiated metric).
The note will often specify whether it takes priority over other debt obligations of the company (senior) or if it ranks behind other debts (junior). The first priority claims on the company’s assets begin with the most senior creditor and then work down through the junior debtors in order – and all creditors are senior to all equity holders.
Now that you have a handle on the terms associated with convertible notes, you can learn why we typically don’t like to use them in our blog series on The Case Against Convertible Notes.