Convertible Note
Definition
A convertible note is a short-term debt instrument that converts into equity during a future financing round, typically at a discounted price. Unlike SAFEs, convertible notes accrue interest and have a maturity date, creating a legal obligation for repayment if conversion does not occur before the note matures.
Overview
A convertible note is structured as a loan that automatically converts to equity when a qualifying financing event occurs (usually the next priced round). The note typically includes a valuation cap (maximum conversion price), a discount rate (usually 15 to 25 % off the next round price), an interest rate (typically 2 to 8 % annually), and a maturity date (usually 18 to 24 months).
The valuation cap and discount give early investors a better price than later investors, compensating them for the additional risk of investing earlier. When both a cap and discount exist, the investor typically converts at whichever mechanism produces a lower price per share.
Convertible notes were the standard early-stage fundraising instrument before SAFEs gained popularity. They are still preferred in some situations, particularly when investors want the legal protections of debt, when operating in jurisdictions where SAFEs lack legal precedent, or when the parties want a defined timeline for conversion via the maturity date.
Example
A $200K convertible note with a $4M cap, 20 % discount, and 5 % interest matures in 18 months. If a Series A occurs at $8M pre-money, the note converts at the $4M cap (lower than the discounted price) plus accrued interest.
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