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Convertible Note

A document which memorializes a loan that can be converted into equity by its holder at a later time, usually once the company has enough operating history to enable a fair company valuation to be ascertained. When the company issues a convertible note, the money is received right away as a loan. In the future, at a specified time or upon a specified event, the loan converts into shares of equity. The number of shares investors are entitled to receive is determined as part of the next round of financing, typically a Series A financing.

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A convertible note is a type of short-term debt instrument that converts into equity, typically in conjunction with a future equity financing round. The investor loans money to a company and, in addition to receiving payment of interest on the principal, the investor receives equity in the company based on the principal amount of the initial investment (in some cases accrued and unpaid interest also converts to equity rather than being paid in cash). The equity amount received upon conversion on the value of the company at the time of conversion and the principal amount of the loan (plus accrued and unpaid interest). A company in its earliest stages may not objectively know or be able to determine its value. Valuation is typically determined during the Series A financing round when there is more data to ascertain the company’s value. Some convertible notes include a discount rate, which compensates early investors for the additional risk they bear by investing earlier in the company. Additionally, a valuation cap may set the outside price at which investors’ notes convert into equity. The document contains provisions regarding the interest rate on the unpaid principal amount of the note, conversion procedures, and triggers regarding the note’s conversion into equity securities of the company, and remedies in the event of default. Conversion of the note may be mandatory or discretionary upon the occurrence of certain events or upon a specified date.