What is a convertible note?

Convertible note

Nicolas Delwaide avatar
Written by Nicolas Delwaide
Updated over a week ago

A convertible note is a form of (short-term) debt that will convert into equity if and when certain events occur, typically at the next equity financing round of the debtor, i.e. the target company.

The investor loaning the money to a target company would receive equity in this company instead of the repayment of the capital plus interest.

Such convertible note has a maturity date by which the company needs to repay the principal amount as well as interest if the conversion event has not occurred.

A convertible note can be secured or unsecured. A secured convertible note means that the company issuing the convertible notes is backing the repayment of its debt by other types of assets (such as claims, real estate, etc.).

The terms and conditions of the convertible note will foresee the formula to calculate the number of shares granted (e.g. valuation floor and cap, discount, etc.) if and when the conversion event occurs.

Holders of convertible notes usually benefit from a discount when the notes convert into equity as a reward of taking the risk of investing earlier and not awaiting the next equity financing round. For example, in case of a 10% discount, if the shares issued during the next equity financing round are valued at 10 euros per share, the convertible note’s principal plus accrued interest converts at a share price valued at 9 euros per share.

In general, convertible notes are known to be rather lengthy and complex agreements (especially due to the interest accruing which then needs to be converted into equity). This is what led Y Combinator to create the SAFE. The BSA-AIR was inspired by the SAFE.

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