Every startup begins with an ambitious founder and a great idea. But from there, they need money to build and grow. The good news is that many investors are looking to give capital to the right startup through various financing options – and one of those options is a convertible note.
To get you started, here’s our Open Source VC convertible note template, plus a quick overview of the terms you should know.
We’ve purpose-built the Open Source VC convertible note for seed and early-stage companies, meaning it has reasonably basic and straightforward terms and a balanced approach between the interests of the startup and noteholders. Later-stage companies will likely use more complex, bespoke, convertible note documents.
It’s important to note that the Open Source VC convertible note is only a template. Founders should only use it as a starting point and then update and personalise the document (with the help of a lawyer) to ensure it meets their specific requirements and circumstances.
What is a convertible note?
A convertible note is a hybrid security that converts into equity upon a predetermined trigger event. Trigger events typically include:
- A qualifying equity financing round (e.g. company raises their Series A round from a credible external investor)
- At an exit event (e.g. IPO, trade sale)
- On the maturity date of the convertible note
Using a convertible note delays the need to determine the startup’s valuation until the startup carries out an equity financing round. This can be helpful for seed-stage startups with limited data points on traction, product and revenue or when there is no clear lead investor for the round.
We also see convertible notes used for internal bridging rounds, where the goal is to use the capital to achieve a milestone that will make the startup more attractive when it goes to raise a larger external round.
Convertible Note Terms
Conversion - discount
A conversion discount is a mechanism to reward the noteholders for their investment risk by granting them the right to convert the loan amount at a discount to the purchase price paid by the investors in the equity financing round.
Discounts typically range from 10% to 35%, the most common being 20%.
The discount rate isn’t always static – it can increase. For instance, if your startup raises a qualifying round in 1 year, the investor gets a 20% discount. If the timeline to a qualifying round is beyond a year, it may go up to 30%.
Conversion - valuation cap
A conversion valuation cap is another mechanism to reward noteholders for their investment risk. A cap is a ceiling on the startup's value, determining the convertible note’s conversion price. Similar to a discount, it permits the noteholder to convert their loan at a lower price than the purchase price paid by investors in the equity financing round.
The interests of founders and investors are misaligned if the convertible note is uncapped (we wouldn’t consider this a vanilla term). Founders want the valuation to be as high as possible, while investors want the opposite, reducing their incentive to help a startup get to a higher valuation due to their introductions and operational support.
Conversion - discount and valuation cap
Convertible notes can include both a discount and valuation cap. Including a discount and valuation cap allows the noteholder to convert their loan into shares in the startup based on the mechanism that yields the lowest conversion price (and, consequently, the most shares). This is the conversion method included in our Open Source VC convertible note.
As a convertible note is a type of loan, the startup is sometimes required to pay interest (either simple or compound interest) on the loan amount. Interest isn’t always included in seed and early investments, but it’s commonly used in later-stage investments.
Unlike a typical loan where you pay interest periodically, it accrues until the conversion event. The total amount of interest is added to the loan amount (called the “outstanding amount”) and converted into additional shares when the convertible notes convert. We’ve included standard simple interest in our Open Source VC convertible note.
When a startup carries out a priced equity financing round (also called a “qualifying financing”), the convertible notes will automatically convert into the class of shares issued in the round.
For example, if the qualifying financing is a Series A round, the convertible notes will convert into Series A Preference Shares. The outstanding amount will convert into shares based on the conversion mechanics explained above – either the lower of the discount rate or valuation cap.
As a qualifying financing automatically converts the convertible notes to shares, sometimes founders and noteholders will want to ensure the value of the raise in the qualifying financing is material to the startup. To this end, a founder and noteholder may agree to make the qualifying financing conditional, meaning that the startup must raise a minimum amount of money at a minimum valuation (as opposed to unconditional, for which any qualifying financing is sufficient).
Qualifying financings are frequently used by later-stage companies concerning larger investments. However, as our Open Source VC convertible note is aimed at seed and early-stage startups, and to ensure simplicity, we’ve included unconditional qualifying financing.
A convertible note will have a fixed maturity date, meaning that if a startup hasn’t already carried out a qualified financing or exit event, the convertible notes either converts into equity or the outstanding amount is repaid to the noteholders (also called “redemption”). Typically, the maturity date ranges from 12 to 24 months from the closing date of the convertible note.
If the convertible note converts at the maturity date, it will generally convert per the valuation cap method described above into the startup’s highest ranking class of preference shares at the time.
Alternatively, if the convertible notes are redeemed, the startup must cancel the convertible notes and repay the outstanding amount to the noteholders. Redemption can be problematic for startups as it may cause them to become insolvent in circumstances where a startup doesn’t have sufficient cash available to pay a noteholder its outstanding amount.
Given these risks, we’ve drafted our Open Source VC convertible note so that the convertible notes automatically convert into equity on the maturity date.
When drafting the convertible note, founders should also address what happens if there is an exit event (which includes an acquisition of the startup or an IPO) before the maturity date. There are three different ways to approach this:
- Repayment of the loan amount plus interest: the noteholders receive their investment amount plus any interest, but nothing else. The convertible notes don’t convert into equity or participate in the IPO or acquisition proceeds. In most circumstances, this is the most founder-friendly, but it’s less appealing for sophisticated investors as the return on their high-risk investment is only the interest of the loan. However, it does provide certainty to noteholders that they will at least receive their loan amount plus interest.
- Conversion right: this provision permits the noteholder to convert the convertible notes into equity (generally using the same discount which is applied to the effective price per share in the exit event and valuation cap mechanisms above). Sophisticated investors prefer this approach as they can share in any upside if the startup is acquired.
- Premium: this approach enables founders and investors to meet in the middle by including a provision that grants the noteholder the right to get their money back with interest, plus a premium. The premium is typically drafted as a multiple of the principal amount of the loan.
In an exit event, a noteholder is commonly granted the discretion to choose either the repayment of the loan amount plus interest or the conversion right. A premium is less common. Later stage companies usually have different considerations for the treatment of convertible notes on an exit event. They generally require conversion in circumstances of an IPO or scrip for scrip company sale (where shares of the company are swapped for shares of the company that is acquiring it).
Advantages of a convertible note
- Speed and simplicity
Convertible note financing can be faster and simpler than equity financing rounds. As convertible notes are classed as a hybrid security, there is no need to issue ordinary shares or create additional classes of preference shares. This removes the need to determine a company valuation, share option prices, and the related tax implications.
- Maintain control
Convertible noteholders are rarely granted control rights (e.g. a board seat or veto rights).
Disadvantages of a convertible note
- Loan → Insolvency
Convertible notes are a hybrid security that may require the investment amount to be paid back. If a startup fails to raise an equity financing round before the maturity date or to carry out an exit event, it may not have the funds to repay the outstanding amount. If the startup defaults on a convertible note, it can be pushed into insolvency.
- Incentive to raise a qualifying round before maturity date
If a startup has reached the breakeven point and doesn’t need to raise money before the maturity date, depending on how the maturity term is written, it may be a penalty to the startup. To avoid an adverse outcome, the startup may be incentivised to raise a qualifying round to set the conversion price.
Disclaimer: This article and the Open Source VC convertible note do not constitute legal advice. You should always seek professional legal advice if you’re considering using this template.