What Is a Convertible Promissory Note?
A convertible promissory note is a debt instrument. An investor lends money to your startup, and instead of being repaid with interest, the loan converts into shares of stock at a later date. Usually, that date is during a future equity financing round.
The note includes a principal amount, an interest rate, and a maturity date. Unlike a traditional loan, the main goal is not repayment but conversion. This structure lets investors back your company early while delaying the tricky question of valuation.
For founders, convertible notes are often faster and cheaper to set up than a priced equity round. You don't need to negotiate a valuation upfront, which can save time and legal fees. However, the terms can be complex, so it's important to understand them fully.
- Principal: The amount of money you borrow.
- Interest: Accrues on the principal, usually paid in additional shares upon conversion.
- Maturity date: When the note must be repaid if not converted.
- Conversion trigger: The event that causes the note to turn into equity.
- Discount rate: A percentage discount on the share price in the next round.
Key Terms in a Convertible Note
The discount rate is a common feature. It gives note holders a lower price per share than later investors. For example, a 20% discount means if the next round's price is $1.00 per share, the note converts at $0.80. This rewards early investors for taking more risk.
A valuation cap sets a maximum company valuation for conversion. If your startup is worth more at the next round, the note converts as if the valuation were the cap, giving the investor more shares. Caps protect investors from overpaying if your company takes off.
The conversion trigger is typically a qualified financing. That means your startup raises a certain amount, say $1 million, in a priced round. When that happens, the note automatically converts. Some notes also convert upon a sale or IPO, known as a change of control.
- Discount rate: Usually 10% to 30%.
- Valuation cap: Often between $1 million and $10 million, depending on stage.
- Qualified financing amount: The minimum raise that triggers conversion.
- Interest rate: Typically 2% to 8% per year, accruing but not paid in cash.
- Maturity date: Usually 18 to 24 months from issuance.
Pros and Cons for Founders
The biggest advantage is speed. You can close a convertible note in days, not weeks. There's no need for a formal valuation, which can be contentious. This lets you focus on building your product and getting to revenue.
Another plus is flexibility. Notes can be structured with various terms to suit both parties. For example, you might offer a higher discount if the investor brings strategic value. You can also delay setting a valuation until you have more traction.
The downside is the debt. If your startup fails and the note hasn't converted, you owe the money back, plus interest. This can be a personal liability if you signed a personal guarantee, which some investors require. Also, the terms can be investor-friendly, potentially giving away more equity than you expected.
- Fast and cost-effective to issue.
- Delays valuation discussions.
- Creates debt that must be repaid if not converted.
- May require personal guarantees from founders.
- Potential for significant dilution upon conversion.
How Conversion Works
When a qualified financing happens, the note converts. The investor gets shares based on either the discount rate or the valuation cap, whichever gives them a better deal. This is known as the 'most favorable conversion' or 'lower price' mechanism.
For example, suppose you raise a Series A at a $5 million pre-money valuation. Your note has a 20% discount and a $4 million cap. The investor would calculate the price per share under both the discount and the cap, then use the lower price. This ensures they get the most shares for their money.
The interest that accrued on the note also converts. So if the investor lent $100,000 at 5% annual interest for two years, the principal plus interest, about $110,250, converts into shares. This means you issue more shares than just the principal amount.
- Conversion price is the lower of the discounted price or cap price.
- Accrued interest converts into additional shares.
- Conversion typically happens automatically upon a qualified financing.
- Founders should model dilution scenarios before signing.
What to Watch Out For
Be wary of notes with a 'most favored nation' clause. This means if you later issue notes with better terms, earlier investors get those terms too. It can complicate future fundraising and create unexpected dilution.
Another trap is a maturity date that's too short. If you can't raise a qualified round in time, you may face repayment demands. Negotiate a longer maturity or include an extension option, especially if you're far from a priced round.
Also, understand the 'no-shop' or 'exclusivity' provisions. Some notes require you to negotiate only with that investor for a period. This can limit your ability to seek other funding. Always read the fine print and consult a lawyer experienced with startup financing.
- Most favored nation clauses can lead to renegotiation.
- Short maturity dates increase repayment risk.
- Exclusivity clauses can restrict your fundraising options.
- Personal guarantees are risky for founders.
- Always seek legal advice before signing.
Alternatives to Convertible Notes
SAFE (Simple Agreement for Future Equity) is a popular alternative. It's not a debt; it's a contract that gives the investor the right to future equity. There's no interest or maturity date, which reduces pressure on founders. However, it may be less familiar to some investors.
A priced equity round sets a valuation now. This is more formal and expensive but gives clarity. It's often used when you have enough traction to justify a valuation. For seed rounds, convertible notes are still common, but SAFEs are gaining ground.
Consider a traditional loan if you want to avoid equity dilution. But banks rarely lend to startups without collateral or a personal guarantee. Crowdfunding or grants might also be options, but they come with their own requirements and timelines.
- SAFEs have no interest or maturity date.
- Priced rounds provide immediate valuation clarity.
- Traditional loans require collateral or guarantees.
- Crowdfunding and grants are non-dilutive but time-consuming.
Sources & references
For further reading, see these general legal resources from the Cornell Legal Information Institute.
- Promissory notes — Cornell Legal Information Institute
- Contracts — Cornell Legal Information Institute
External links open in a new tab. These sources are provided for general information only and are not legal advice.