Convertible Notes 101

Introduction

This article provides an overview of Convertible Notes. You can view these articles for instructions on Creating a Convertible Note, or Uploading a Convertible Note.

Convertible Notes Overview

What is a Convertible Note (also known as a Bridge Note)?

A convertible note is a short-term loan often used by companies to raise money from investors, generally before or between rounds of financing.

How does it work?

A convertible note is a loan from an investor to the company. Instead of being paid back in cash, the loan converts into equity, typically in the future when the company raises a bigger round of funding.

Why would a company use convertible notes?

Raising money through convertible notes can be advantageous to both the company and the investor. Convertible notes allow the company to raise capital and focus on growing their business before the process of an equity financing round. For investors, there are terms of the convertible note that can result in a bigger return on their initial investment. Additionally, the conversion happens in the future, meaning the company may be more profitable

What are some key terms?

Convertible debt usually includes a discount rate and/or a valuation cap:

Discount Rate

Many deals offer investors a discount (typically ranging between 10-30%) on the preferred stock that they will receive when their note converts. This discounted price per share is used to calculate the resulting number of shares that convert from the investment of the original note, which can mean the investor can receive additional shares than if they were paying full price.

For example, let's say that the terms of a convertible note include a 20% discount. If the price per share of the preferred stock is set to $1.00, the notes will convert using the discounted rate of $0.80.

Interest Rate

As with other forms of debt, some convertible notes may accrue interest over the life of the note.

Valuation Cap

With a valuation cap, the investors are looking to cap the dilution of their investment by establishing a maximum valuation that will apply to the conversion in the future financing. In these cases, if your company has a higher-than-expected valuation during the equity financing, the note holder's conversion price will be calculated using the cap rather than the valuation used by the new investors.

What are the key documents?

Note financings involve a Note Purchase Agreement (which governs the financing as a whole and contains representations and warranties from the company), and a Note for each investor (the “IOU” which contains the terms of the debt and details on when it will convert to equity).

Board approval for these financings is required and some companies choose to get stockholder approval as well. Companies may also consider holding multiple closings to accommodate their investors' timing requirements.

Fidelity Private Shares LLC provides cap table management and other administrative services to private companies and their equity compensation plans.

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