What Is a Convertible Promissory Note and When to Use It

A convertible promissory note is a type of financing instrument that can be a game-changer for startups and small businesses.

It's essentially a loan that can be converted into equity in the company at a later date. This flexibility makes it an attractive option for businesses that are unsure about their future growth or valuation.

Convertible notes are typically used in early-stage financing rounds, allowing investors to provide capital to companies with less risk.

Related reading: Convertible Equity Financing

A convertible promissory note is a type of debt instrument that combines elements of both debt and equity. It's a short-term debt that can be converted into equity at a later stage.

Startups often use convertible promissory notes to raise capital during their early growth stages or bridge financing between rounds of equity funding. This allows companies to secure funding while deferring the valuation of the company until a later date.

Convertible promissory notes are typically seen at the early stage, seed stage, and pre-seed stage. They're designed to convert into equity at specified "events" like the next round of equity funding.

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There are two types of situations where you'll see convertible promissory notes used. First, in early stages, no one knows what the valuation of a company is, so they have a conversion cap, which is the maximum equity value that the investment or loan converts into in equity if another round comes in.

Convertible promissory notes are straightforward to document. The standard terms in a convertible promissory note include:

A convertible promissory note is a loan that can convert into equity, often used in early-stage startup financing. This type of financing allows investors to benefit from future equity without having to worry about valuation discussions upfront.

The key terms associated with convertible promissory notes include the discount rate, which allows noteholders to purchase equity at a lower price compared to future investors. The discount rate is a percentage applied to the valuation of the startup during the conversion.

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The valuation cap sets an upper limit on the valuation at which the convertible note can convert into equity, providing protection for investors. This cap ensures that investors receive a fair share of ownership, even if the company's value skyrockets.

Convertible notes may accrue interest over time, increasing the principal amount. The interest accrued can convert into additional shares upon conversion.

The maturity date is the deadline for the repayment of the convertible note, signifying the point at which the startup must repay the principal and any accrued interest. This date is crucial for both investors and startups, as it affects their financial obligations.

The conversion ratio determines the number of shares of equity that the convertible note can be converted into. This ratio is typically expressed as a ratio or formula specifying the number of shares per dollar of the note's principal.

The conversion events specified in the note will trigger the conversion right. These events can include subsequent equity financing rounds, an initial public offering (IPO), or the company's acquisition.

Here are the key elements and features of a convertible promissory note:

Convertible promissory notes are a popular choice among startups for several reasons. They offer a simpler and faster fundraising process compared to equity financing, allowing companies to raise capital without immediately negotiating a company valuation.

Companies in the early stages of startups often use convertible promissory notes during seed or pre-seed funding rounds. This financing option is also utilized as a bridge financing tool, providing temporary financing between equity rounds or during a transition.

In cases where rapid funding is needed, convertible notes offer an efficient option, involving fewer legal and administrative complexities compared to negotiating and executing a priced equity round. They can be beneficial for companies with smaller financing needs, as conducting a small equity round might not be practical due to the associated costs and potential negative perception.

Here are some key differences between convertible promissory notes and SAFEs (Simple Agreements for Future Equity):

A SAFE (Simple Agreement for Future Equity) is a contractual right to future equity, not a loan, which means investors aren't expecting repayment. This is a key difference between SAFEs and convertible promissory notes.

SAFES typically don't have a maturity date, which means there's no set deadline for repayment or conversion. In contrast, convertible promissory notes do have a maturity date and may require repayment if not converted.

Convertible promissory notes often come with interest rates, which means investors will receive interest payments. SAFEs, on the other hand, do not have interest rates.

One of the benefits of SAFEs is their simplicity. They are more standardized and easier to understand than convertible promissory notes, which have moderate legal complexity.

Here's a comparison of SAFEs and convertible promissory notes:

Convertible promissory notes are a popular choice for startups and early-stage companies, and for good reason. They offer a simpler and faster fundraising process compared to equity financing, with no immediate need to negotiate a company valuation.

Companies in the pre-valuation stage, where it's too early to determine a fair company valuation, can benefit greatly from convertible notes. These notes allow founders to raise capital without placing an explicit valuation on the startup.

For another approach, see: Valuation Cap Convertible Note

If you're in a situation where you need to fund operations between equity rounds or during a transition, convertible notes can be a lifesaver. They provide flexibility and speed, making them a practical option for early-stage fundraising without sacrificing long-term strategy.

Convertible notes are also useful for founder loans, where founders inject personal funds and want the option to convert those loans to equity. This option allows founders to maintain control and flexibility in their fundraising efforts.

Here are some scenarios where convertible promissory notes are especially useful:

Convertible promissory notes offer several advantages for both investors and companies. They provide the potential for high returns if the note converts into equity, allowing investors to benefit from the company’s success.

For investors, convertible promissory notes offer debt protection, ensuring that investors have a higher priority in recovering their investment compared to equity holders if the company fails. This is a significant advantage for investors who want to minimize their risk.

Companies can access capital quickly without an immediate valuation, allowing them to raise funds rapidly. This is especially beneficial for startups and early-stage companies that need to move quickly.

One of the key benefits of convertible promissory notes is that they help preserve ownership and control for companies by minimizing immediate dilution. This means that companies can maintain a larger stake in their business without having to give up too much equity.

Here are some key advantages of convertible promissory notes:

Convertible promissory notes also offer flexibility in determining the conversion terms, allowing for negotiation with individual investors and tailoring terms to their preferences. This is a significant advantage for companies that want to tailor their financing arrangements to their specific needs.

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A convertible promissory note contract typically includes several key sections that outline the terms of the loan. The principal and interest amount, as well as the interest rate, should be clearly stated.

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The maturity date is also crucial, as it outlines exactly when the company will repay the principal and interest if the note hasn't been converted into equity. This can be a fixed date or tied to a specific event, such as the company raising a certain amount of financing.

The conversion process is another important aspect of a convertible promissory note contract. This can be triggered by the company raising a certain amount of financing, or it can be left up to the investor's discretion. The mechanics of conversion should be clearly outlined, including how the investor will receive company shares in exchange for the note.

Here are the key components of a convertible promissory note contract:

Additionally, convertible promissory notes often include financial mechanisms such as a valuation cap, discount rate, and interest accrual, which can impact the conversion value and equity stake for the investor.

If a convertible promissory note's maturity date passes without additional financing, the company has a few options to consider.

The company can repay the investor in full, including any accrued interest. This can be a costly option, but it ensures the investor gets their money back.

Alternatively, the company can request an extension of the maturity date. This might give the company more time to secure funding, but it's essential to negotiate this with the investor.

The company can also convert the note into preferred stock or common stock. The specific terms of the note and the negotiation between the company and the investor will determine which option is chosen.

Here are the possible courses of action when a maturity date passes without additional financing:

A convertible promissory note contract is a critical document that outlines the terms of the investment.

The contract should specify the principal and interest, including the interest rate, to ensure both parties are on the same page.

The maturity date is also essential, as it outlines when the company will repay the principal and interest if the note is not converted into equity.

The mechanics of conversion are crucial, as they outline how the investor will convert the note into equity, usually requiring the investor to hand over the note in exchange for company shares.

Payment terms should also be clearly outlined, including how the repayment will work and how interest will be accrued.

Representations and warranties of the lender are also required by securities laws, explaining what the investor can do with their equity and the note before conversion.

General provisions should cover any other issues that either party wants to address, including jurisdiction and amendment procedures.

Here are the key sections to include in a convertible promissory note contract:

Convertible promissory notes can be complex, and their classification as securities can vary. They may not always be considered a security, especially if they're treated purely as a loan and never converted into equity.

Consulting with legal counsel is a good idea to ensure compliance with applicable securities regulations, as the implications can be significant.

Companies should be aware that the classification of a convertible promissory note as a security can have important implications, and it's best to seek professional advice to navigate this complexity.

A convertible promissory note is not always considered a security, despite often representing an investment of money with expected profits derived from the efforts of others. This classification can vary depending on the specific circumstances.

If a note is never converted into equity and is treated purely as a loan, it may not be considered a security under federal or state law. Companies should consult legal counsel to ensure compliance with applicable securities regulations.

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Convertible promissory notes can be complex, but it's essential to understand their classification as securities. Not always considered a security, a note may be treated purely as a loan if it's never converted into equity.

Startups often use convertible promissory notes to raise capital during early growth stages or bridge financing between rounds of equity funding. This allows companies to secure funding while deferring the valuation of the company.

Companies should consult legal counsel to ensure compliance with applicable securities regulations, as the classification can vary. Due to the complexity and potential implications, it's crucial to get it right.

A convertible promissory note typically includes the principal, interest rate, maturity date, and details of what will happen if there is a default. The equity conversion will include an explanation of the event that will trigger the conversion.

A model convertible promissory note is available for early-stage financings, created by the Angel Capital Association to balance the rights of founders and investors. This model combines common convertible promissory note provisions with "best practice" provisions often found in side-letters or note purchase agreements.

The model term sheet and convertible note were shared with several leading angel groups for feedback and were updated to reflect changes in applicable laws and market terms. You can find the most current template on the Angel Capital Association website.

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The proposed Convertible Promissory Note has several key additions that reflect provisions often found in note purchase agreements and side letters required by early-stage investors. These additions include expanded representations and warranties, participation rights in future financings, and select information rights.

Some of the key additions to the model convertible promissory note are:

A convertible promissory note can be a great financing option for early-stage startups, but it's essential to understand the key terms and risks involved.

Convertible promissory notes delay valuation discussions until a later financing round, allowing investors to benefit from future equity.

Key terms to focus on include interest rate, maturity, conversion trigger events, discount rates, valuation caps, and prepayment clauses.

These terms can have a significant impact on both investors and startups, so it's crucial to have legal clarity.

Investors face risks such as potential loss of priority, while startups risk excessive dilution.

Here are some key takeaways to keep in mind: