A convertible note is a type of loan that converts to equity once certain terms have been satisfied. It is a very good way for a start-up company to achieve funding in circumstances where ascertaining the company’s value is difficult or not possible because there are insufficient business or operational indices to allow an accurate valuation.

When the convertible note is issued, the loan is provided to the company to utilise the money and begin to build value in the business. Normally, the convertible note will mature at a specific date, or when a later round of financing is achieved, for example, through a Series A financing. At this point, the loan will convert to stock in the company at the valuation at which the financing is made, but with benefits such as additional shares and interest to compensate the note holder for their early investment. The benefits that accrue to holders of a convertible note are determined by the discount rate and the valuation cap ascribed to the note. Depending on the terms of the note, it may contain either the Discount Rate or the Valuation Cap, or both.

The convertible note will include a provision that provides the note holder with a discount on the value ascribed to the shares issued at the maturity date or when a Series A financing is made. This is when the loan made under the note converts to shares. So, if the Series A financing is made at $1 per share and the convertible note has a discount rate of 20%, the note holders will acquire their shares at $0.80 per share. A 25% discount on the share price paid by the Series A investors.

The convertible note will also have a Valuation Cap, which places a ceiling on the value that the company can be priced at for the purposes of converting the note to shares. To give an example, assume the valuation cap on a convertible note issued by an agriculture company is set at $4 million. The company uses the money loaned by the note holders wisely, and by the time the Series A financing comes around, the company is valued at $8 million at $1 per share. In that case, the note holders will convert their loan to shares at $0.50 ($4m divided by $8m), which is half the price that the Series A investors paid for the same shares. We should be clear that only one method can be used to determine the conversion rate. If both are included, depending on the discount rate and valuation cap applied under the terms of the note (and the valuation achieved in the Series A round), the note holders will be able to elect which method is used to achieve the most beneficial share conversion.

As we mentioned earlier, the convertible note is a type of loan, and therefore, the company issuing the note expects to pay interest to the note holders. The rate of interest will vary, but one can expect interest in the range of 5% - 7% annually to be applied on the total amount loaned under the convertible note. Unlike a normal loan, interest is not paid periodically, but accrues over the term of the note. The total amount of interest due is added to the loan amount and converted into shares on maturity or when the Series A financing occurs.