When it comes to raising financing for a company, there are many ways to do it, one popular method is through the use of convertible notes. In this article, we provide an overview of convertible notes, as well as the three most common terms you may come across in a convertible note: interest rate, conversion discount and maturity date. Additionally, we’ll look into how they typically work and provide some hypothetical examples.
What is a Convertible Note?
Let’s start by defining what a convertible note is. A convertible note is a form of short-term debt, typically issued to investors of a company in exchange for stock at a later time. For example, it may be debt that automatically converts into shares of preferred stock upon the closing of a financing round. This means that, when investors loan money to a company, at some future date they receive shares of preferred stock instead of getting their money back with interest. In many ways, convertible notes act as an IOU, but instead of paying cash back to the investor, the company pays equity.
The usual scenario is that the investor will have their note converted into some “future to-be-designated” series of preferred stock. If that “future” financing does not happen, the note may be convertible into an existing series of preferred stock or into common stock.
How do Convertible Notes Work?
It’s important to know when and why companies would issue convertible notes. The usual situation is that the company may not be ready for a financing round yet, but may be in need of additional operating capital.
As a hypothetical example, let’s say that the company raised money in a Series A financing round, and anticipated a Series B financing round in two years. However, prior to that 2-year period, the company needs additional funding. As the company is not yet ready for their Series B financing round, they may look to investors to loan the company funds to tide-them over until that Series B financing round is done. This may help investors to bring money to the table and convert that debt into equity at a later time.
The typical benefit seen in convertible notes is that they may enable companies to secure funding without having to define the value upfront, while investors may have the opportunity to acquire a stake in the company.
Convertible Note Terms
Typically, there are three main features of convertible notes, aside from maturity. Below, we’ll cover each convertible note feature individually, but one thing to keep in mind is that these features aren’t always required. Instead, they are negotiable levers, and may help you better approach negotiation if you understand them well. It may also be beneficial to know that convertible notes regularly include both interest accrual and discount ratios.
Term 1: Interest Rate
Many of us are familiar with interest rates, they are how most lenders make a profit. Convertible notes are a debt instrument and usually accrue interest.
Interest rates have two accrual methods, simple or compounding, and they may carry a time frame for when and how the interest rate is calculated. A good way of thinking about the concept of interest is to think of the monthly interest that accrues on your car loan or mortgage. These terms are all negotiable, but interest is a fairly standard term.
Term 2: Conversion Discount
A conversion discount refers to the negotiation of a lower share price when a convertible note is converted to stock. Convertible note debt typically converts into equity in the next preferred round of financing, a series seed A, B, C, etc. With a conversion discount, more stock is being bought with less cash.
Here’s an example: In an upcoming financing round, a company raises money at $1.00 per share, and an investor had previously invested $100,000 on a convertible note with a 20% conversion discount. The investor would receive stock at $0.80/share, instead of $1.00. That would mean receiving 125,000 shares of stock, rather than the 100,000 shares that the original $100,000 would buy if the investor had waited to participate in the round directly.
Term 3: Maturity Date
The Maturity Date is typically the date on which the note must either be converted or repaid and is the last date on which interest will accrue unless the note is amended.
How Do Convertible Notes Affect Dilution?
When a company raises funding, it typically awards equity to its investors, which dilutes ownership stake held by current shareholders. Convertible notes are no different. They are investments that convert at a later time into equity and depending on the nature of the terms set in the note, the amount of dilution will be subsequently affected.
The Risks of Convertible Notes
Investors always face the risk that they won’t be repaid and may lose the entire investment. Convertible notes are speculative in nature, and it is not mandatory for convertible notes to include a clause that guarantees conversion on maturity. In some cases, if a company cannot raise the appropriate equity financing, then it cannot repay the notes.
How Shareworks Can Help
Shareworks can also help you manage other types of debt equity instruments such as SAFEs (Simple Agreement for Future Equity) and KISS (Keep it Simple Security) notes.
Shareworks is a powerful tool that keeps you confidently in control of your equity and enables you to make the optimal choices for your company and shareholders. To learn more, contact our team to set up a private demonstration of our equity management solution.
This material is provided for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or to participate in any trading strategy. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it.
Shareworks by Morgan Stanley and Morgan Stanley Smith Barney LLC recommend that investors independently evaluate particular strategies and/or investments, and encourages investors to seek the advice of a financial professional or Financial Advisor. The appropriateness of a particular strategy and/or investment will depend upon an investor’s individual circumstances and objectives.
Investing in the market entails the risk of principal loss as well as market volatility. The value of all types of investments may increase or decrease over varying time periods.
Convertible notes are highly speculative and may result in a value less than the original amount invested. Investors could lose the entire investment.
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