Convertible Note

A convertible note (also known as a 'convertible promissory note' or 'convertible debt') is a clever financial instrument that's a bit of a chameleon. On the surface, it's a loan—an investor lends money to a company (usually a startup) which promises to repay it with interest. But here's the twist: instead of being repaid in cash, the loan is designed to “convert” into equity (i.e., ownership shares) at a later date. This typically happens when the company secures its first major round of funding, known as a priced equity round. Why do this? It's a simple way for young companies to raise money quickly without having to agree on a specific company valuation—often the most contentious part of early-stage fundraising. For the investor, it's a high-risk ticket to potentially get in on the ground floor of the next big thing, with some built-in perks for taking that early leap of faith.

Think of a convertible note as a placeholder for a future investment. The company gets the cash it needs now, and the investor gets a promise of future shares at a discount. The “when” and “how” of this conversion are governed by a few key terms.

Every convertible note is a recipe with a few crucial ingredients. Understanding these is essential to knowing if you're getting a good deal or a raw one.

• Valuation Cap: This is arguably the most important term for an investor. The valuation cap sets the maximum company valuation at which your investment will convert into equity, regardless of how high the valuation is in the next funding round. For example, if the cap is $5 million and the company later raises money at a $10 million valuation, your investment converts as if the company were only worth $5 million. This means you get more shares for your money, rewarding you for your early risk. It’s your primary protection against being diluted by future success.
• Discount Rate: This is a straightforward discount on the price per share paid by the investors in the next funding round. A typical discount rate is 15-25%. If new investors pay $1.00 per share and you have a 20% discount, you get your shares for $0.80. Most notes allow the investor to use either the valuation cap or the discount rate—whichever gives them a better price.
• Maturity Date: This is the note's expiration date. If the company hasn't raised a qualifying funding round by the maturity date (usually 18-24 months), the investor typically has a choice: either demand repayment of the loan plus interest or convert their investment into equity at a pre-agreed (and usually very low) valuation. The former option is rare, as a startup unable to raise more funds is unlikely to have the cash for repayment.
• Interest Rate: Like any loan, a convertible note accrues interest. However, this interest is rarely paid in cash. Instead, the accrued interest is usually added to the principal amount and also converts into equity, giving the investor a little extra ownership for the time their money was at risk.

Convertible notes are the domain of angel investors and venture capital funds, but as private markets become more accessible, ordinary investors may encounter them. Here’s what you need to know.

The allure is clear: you're betting on a tiny startup before the rest of the world has a chance. If the company takes off, the valuation cap and discount rate act as powerful return multipliers. You get rewarded for your foresight and early-stage risk with a better deal than later investors. The process is also faster and involves lower legal fees than a traditional equity round, allowing the startup to get back to building the business—which is what you want them to be doing!

This is not an investment for the faint of heart. The risks are substantial.

• Deferred Valuation, Not No Valuation: You're kicking the valuation can down the road. If the company fails to raise another round, you're left holding a loan to a likely-insolvent company. Your investment could go to zero.
• No Say: Until the note converts, you are a lender, not an owner. You have no shareholder rights, no voting power, and no say in how the company is run.
• Dilution and Bad Terms: A high valuation cap or a low discount rate can neuter the benefits of investing early. If the cap is set too high, it might offer no real benefit over what later investors get.
• Default Risk: The most common outcome for a startup is failure. Your convertible note is a form of unsecured debt, meaning if the company goes bankrupt, you're unlikely to see a penny back. This is a severe form of credit risk.

At first glance, convertible notes seem like the polar opposite of value investing. Value investors, in the classic sense taught by Benjamin Graham, look for established businesses with predictable cash flows and a definable intrinsic value—things a pre-revenue startup utterly lacks. However, the spirit of value investing is about getting more value than you pay for. In this light, a convertible note can be viewed through a value lens. The discount rate and valuation cap are, in essence, a pre-negotiated margin of safety. They are contractual terms designed to ensure you pay a lower price than the next “market” valuation. A value-oriented approach to a convertible note wouldn't involve a discounted cash flow analysis. Instead, it would involve a ruthless assessment of:

• The founding team's experience and integrity.
• The potential size of the market for their product.
• The fairness of the conversion terms.

Ultimately, investing in convertible notes is a form of venture capital. It requires a portfolio approach—making many small bets with the expectation that most will fail, but one or two big winners will generate massive returns to cover all the losses and then some. It's a high-stakes game, but for those with the right risk tolerance and an eye for a good deal, it can be a thrilling one.