Convertible notes: Investing in debt instruments

Convertible notes are common instruments used for early-stage investing, particularly for startups and companies that intend to raise subsequent venture capital.

For investors, convertible notes provide an alternative means to invest in the early stages of a startup they believe in. Of course, like all investments, they come with their own list of pros and cons.

What is a convertible note?

Convertible debt is a simple, unsecured loan (or “note”) that converts into stock, typically at a discount to the price per share paid at the next equity round.

Convertible note terms

There are five key terms to understand when evaluating a convertible note. It’s important to remember that, while these terms are generally applicable to most notes, each instrument is unique so investors should review companies’ offering documents specifically

1. Principal: The amount of money an investor loans to a company. This is the dollar amount your interest payments are based on.

2. Interest rate: The percentage of interest due (on the principal) while the convertible note is still a debt instrument (pre-conversion). Interest accrues on the note and is not paid out until maturity, if at all.

3. Maturity date: If the note does not convert by the maturity date (deadline), the investor may have the right to “call” the note and receive repayment of their principal plus accrued interest. Typical maturity dates range between 18 and 24 months from investment; maturity may accelerate upon a qualifying financing or liquidity event.

4. Qualified financing: This method mandates that a company can only convert the notes if they receive subsequent financing at a higher valuation (up round). In other words, qualified financing ensures investors’ shares will not be diluted if the value of the company goes down.

5. Valuation cap: Not to be confused with the startup’s valuation, the valuation cap sets the maximum limit at which a convertible note can convert into equity. If the future valuation round is higher than the valuation cap, then the investment converts to equity at the lower valuation cap. 

Example: 

• Convertible note valuation cap: $5M  

• Company value at the time of conversion: $10M 

Result: Investors’ convertible notes will convert at the $5M (lower) valuation cap. This gives the investor equity to their investment in exchange for taking early risk.

1. Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. When a company issues convertible notes, the discount rate is used to calculate the conversion price—the price at which the notes can be converted into equity. The higher the discount rate, the lower the conversion price. The discount rate is usually set at a premium to the interest rate on the notes to compensate investors for the risk that they may not be able to convert their notes into equity.  

Example:

• Convertible note valuation cap: $5M 

• Discount: 20% 

• Company value at the time of conversion: $4M

Result: Notes would not convert based on the valuation cap since it is higher than the new valuation. Instead, the conversion would be based on a discount of 20%, and investors would receive a valuation of $3.2M.

Pros and cons of convertible notes

Although there are benefits to their use, convertible notes do have drawbacks that investors should be aware of. It can be difficult for new investors to establish whether the terms of a particular note offering are fair, driving some away from deals financed with convertible notes. For some, waiting until a priced round is deemed a more prudent move, even if they will most likely pay a higher price.

Pros

Upside potential without committing to a set valuation

Although a startup may look promising, not having a clear track record makes it hard to set a valuation. This makes some investors uneasy, but convertible notes can actually offer investors some protections in lieu of a valuation—along with upside potential—without committing to a set price.

Potential to reduce early downside risk

Since debt holders often have priority over equity holders if a company is dissolved, they likely have the right to get paid back ahead of them. Practically speaking, though, although the risk may be reduced, there is still a chance you will lose your entire investment. 

Ability to share in greater upside than traditional debt holders 

Traditional debt holders receive a fixed return with no additional upside if the company does well. Convertible note holders have the ability to convert to equity, giving them potentially the same upside potential as equity holders depending on the specific terms of the instrument and offering.

Cons

May be harder to evaluate 

With traditional debt securities, yields or investment multiples are defined and based on projected cash flow. Convertibles work differently and may come with varied discounts, valuation caps, and conversion provisions which make direct comparisons more challenging.

To combat this challenge, consider maintaining a well-diversified portfolio rather than investing everything into one particular investment, and never invest more than you could afford to lose.

Lack of Ongoing Payments

Interest in convertible notes accrues over the term of the contract and rarely provides immediate returns. 

In contrast, with revenue sharing notes, the borrowers agree to pay the lenders a percentage of their revenue (for a particular period of time) until the total amount borrowed is repaid. 

Payments, if any, may vary monthly and aren’t tied to an interest rate. Instead, they are based on something called an investment multiple.

Lack of Control 

Convertible noteholders generally have little to no control over the company. Prior to conversion, investors have no voting rights. In the event the note is converted, voting rights are typically very minimal or non-existent.

For smaller investments, this lack of control is similar to owning a small fraction of an S&P 500 company. If you wish to make a larger investment and take a more active role in the company, you’d need to take a careful look at the structure of the deal to determine if a convertible note investment would meet your goals.

Tax liabilities

Even when interest is accruing and not disbursed to investors (unrealized), investors are still required to report them on their tax returns as if they have been paid out (realized). This means investors will have presently taxable income without having received any cash. 

{Not tax advice}

Is a convertible note right for you?

A convertible note provides a mix of debt and equity advantages (and disadvantages) for investors.

Convertible notes are most commonly issued by early-stage companies. These companies provide the potential for higher returns but may be harder for individual investors to evaluate effectively.

Startups and other early-stage companies are increasingly turning to platforms like Republic to help them connect with investors. Republic conducts diligence on companies hosted through OpenDeal Portal LLC and OpenDeal Broker LLC to ensure their leadership team and business plan meet specific standards. This supports investors in making informed investment decisions based on the terms of the note and information in the offering documents.

Investors will need to look at the terms of each note and see how it fits into their investment objectives and overall portfolio. A good starting point is to explore deal pages and learn what each term means.

Crowd Convertible Promissory Note 

A Crowd Convertible Promissory Note, or Crowd Note, is Republic’s version of a convertible note.  Although the terms of each instrument vary per offering, there are some common characteristics. Noteholders generally receive a claim to their principal and interest and the right to receive equity of the company under certain specified circumstances. 

The Crowd Note contains some of the following characteristics. Please review each deal's offering documents independently as there are variations of the Crowd Note: 

1. Principal. The actual amount invested by the noteholder in the Crowd Note. 

2. Interest. The interest rate that accrues on the principal amount. 

3. Discount. The “discount” to the price per share of the First Equity Financing.  A discount is meant to incentivize investors to invest earlier when an investment is riskier. 

4. Maturity date. The time at which the Crowd Note becomes due and payable. Some Crowd Notes may contain a prepayment clause, however, they often do not. With the Crowd Note, if the note has yet to convert (assuming there is no maturity date extension), the “Nominee,” at the direction of the majority of noteholders, may elect to convert the Crowd Note to equity or choose to call on the note for payment of principal and interest. 

5. Valuation cap. The cap on the valuation the notes may convert at an equity financing. The Crowd Note uses a pre-money valuation rather than a post-money valuation.  

6. Conversion events. The “convertible” portion of the Crowd Note refers to the note converting from a debenture to equity.  The Crowd Note may convert into equity on the occurrence of various events, including a subsequent equity financing event (at the company’s discretion), reaching the maturity date of the notes before a subsequent equity financing, or a liquidity event (change of control or initial public offering). There may be other events that trigger conversion, so it’s important to review the specific Crowd Note being offered. In some instances, even upon conversion, the upside may be limited to a specified interest. 

7. Nominee.  The Crowd Note leverages a Nominee to act on behalf of noteholders as agent and proxy. The Nominee receives notices and communications on behalf of noteholders and is authorized and empowered to streamline the custodial process for investors.