Convertible notes are financial instruments used to raise funds in the private market and have some overlap with properties of equity and debt. In this blog, we will introduce them and cover specific considerations investors should be aware of.
Convertible notes, also known as convertible bonds, generally include an annual interest rate provision. Interest may be paid periodically, or it may accrue and become payable at a later date. However, similar to a stock option, a convertible note can be exchanged (converted) to company stock either at the discretion of the investment holder or after a trigger, typically an equity financing event defined in the provisions of the convertible note. The number of shares into which the note may convert depends on how much principal and interest remains unpaid and on the price at which the notes will convert. This price may be explicitly defined in the note, or it may depend upon the pricing of an equity financing event.
Properties of Convertible Notes
There are a few key properties of convertible notes in the private market. These provisions include:
Principal & Interest
The principal is the loan amount from the investor (the investment), which then accrues interest from when the note is issued to when it is converted or repaid. The interest rates for convertibles are typically lower than straight debt instruments and often range from 3-5%. This interest can accrue and remain unpaid until there is an equity conversion event, at which time the amount of funds available for conversion include the investor’s principal and accrued but unpaid interest.
The maturity date is the date when the note becomes due. An original term length of 12-24 months is common, but it is not unlikely that the maturity date, or the loan’s “due date”, will be extended, sometimes to accommodate a future equity financing round. However, investors can technically request repayment when the note has matured.
The discount rate in the terms of a convertible note is meant to provide investors with a “reward” for their early investment with the right to convert the loan at a reduced price using a discounted percentage of the original purchase price. Discounts most commonly range from 10-35%; a discount of 20% is currently typical. The discounted conversion price helps incentivize investors to invest earlier and take on the risks associated with that early investment.
A valuation cap is a ceiling on the value of the company used in a conversion calculation; it limits the price at which the note converts. This is typically less than the pricing of the equity financing round that triggers the conversion. Similar to the discount, this incentivizes the investor to purchase in early stages.
If a note has both a discount rate and a valuation cap, the conversion price is typically the lower of the discounted round price or the price resulting from dividing the valuation cap by the fully-diluted capitalization of the company immediately prior to the equity financing.
The goal of a convertible note investment is to convert to equity at some point in the future. However, this is dependent on successfully attracting and closing a subsequent equity financing rounds. This is the most common method of conversion. Some convertibles may offer a conversion provision where the notes automatically convert to equity at the maturity date.
Potential Benefits and Limitations
Convertibles notes are structured in a way that can be simple to document from a legal perspective and are typically used for early or bridge rounds. You can read more about convertibles in bridge rounds in our recent blog, Understanding Bridge Rounds. Discounts and valuation caps can provide a “perk” for investors to take on the associated risks of early-stage private market investing. Because there are no valuations in convertibles, just valuation caps, this can be an advantage for earlier stage companies that do not have the historical financials to accurately represent the company’s value.
However, conversion of these notes to an equity stake are often dependent on future equity rounds and if they are not completed, the note will remain as a debt, which could result in the issuer defaulting on the loan. If a note does convert, there is no guarantee that the equity stake will see a successful exit.
Putting it All Together
Convertible notes are unique financing instruments that start off as debt and have the potential to convert to equity depending on factors like future equity financing. Many bridge rounds are structured as convertibles, and deal terms like valuation cap and discount rates are intended to reward investors for taking on early-stage investing risk. However, the specific terms of convertible note offerings can vastly differ and it is important to be informed of the risks and implications.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.