A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. This fundraising tool allows an investor to loan money to a startup and — instead of a return in the form of principal plus interest — receive equity in the company.
Sometimes, convertible notes come with valuation caps (i.e., capped notes), which effectively cap the price at which notes will convert into equity, providing convertible note holders with equity-like upside if the company takes off out of the gate.
Are convertible notes good for startups?
If an early-stage startup is ready to raise money, but its valuation hasn’t been established yet, a convertible note can serve as a good fundraising option. Convertible notes allow companies to delay being valued until an equity funding round, extending their time to build a product and flesh it out.
Why are convertible notes sometimes terrible for startups?
The big risk with convertible notes is if future equity rounds don't happen, the convertible note will remain debt and thus require redemption, potentially pushing still-fragile companies into bankruptcy.
What happens to convertible note if startup fails?
- Because the convertible note is debt, its repayment priority comes before any equity, including any other investors and any holders of common stock (such as founders or employees.) That means if the company has any residual value left (e.g., selling the chairs or money in the bank), it's used to pay convertible note holders.
- But this is rarely an issue because if the startup fails that quickly, there is typically nothing left, so everyone — including the convertible note holders — walks away empty-handed and moves on to the next venture.
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