What is a Convertible Promissory Note?
What is a convertible promissory note? At the most superficial level, it is a debt tool for investors or lenders to give a startup capital. Convertible promissory notes are typically seen at the early stage, seed stage, and pre-seed stage. The note is designed to convert into equity (typically preferred stock) at specified “events” like the next round of equity funding.
There are two types of situations where you will see convertible promissory notes used.First, at these early stages, no one knows what the valuation of a company is. So, they typically have a conversion cap which is the maximum equity value that the investment or the loan converts into in equity if another round comes in. That’s generally what everyone’s planning for with a convertible promissory note.
Second, there are situations where convertible promissory notes are used for a bridge round where the company is not a superstar so-to-speak, In this instance, the investors will put more money in themselves because the business can not raise capital from outside investors. So they’ll typically use a promissory note, convertible, and often it will convert at the next round. However, we are seeing extensions more and more often for hot companies that want to take on some additional capital from existing investors quickly (so that the founders can avoid doing a real fundraise process).
Convertible promissory notes are straightforward to document. For more information on convertible note terms, you can check out this video.
Standard terms in a convertible promissory note:
- A debt tool for investors or lenders to give a startup capital
- Seen most in early stages (Pre-Seed, Seed, Series A)
- Idea is to convert from debt into equity at the next funding round
- Typically have a conversion cap, which places a maximum valuation that the investors will pay for their shares at conversion
- Usually has a discount rate, which is a discount to the share price of the priced round that causes the conversion
- There are times that a convertible promissory note is used for a bridge round
Straightforward tool and easy to document!
Again, promissory notes are a favorite, simple tool for angel investors. It is debt and not equity. So if the company gets sold, the promissory note should get paid back first before management or common holders participate.
The conversion cap and the discount rates can complicate the capitalization table modeling at the moment when the next financing round happens. We recommend working with an experienced law firm, who can help guide you through this. And it’s important to realize that the greater the number of converts, caps and discounts that your company has the more complicated the conversion process is going to be!
At the heart of it, a convertible promissory note is something that angel investors and venture capitalists use to invest in startups. It is done in the hopes that a startup changes the world and that the investors have a great return on that investment.
