June 22, 2022 |

What Are Convertible Notes and Should I Be Using Them?

Exploring business fundraising options.

Convertible notes are one of the most flexible and useful instruments in the fundraising tool kit. For both issuing companies (issuers) and investors, the convertible promissory note offers the benefits of equity financing with some of the protections of debt capital.

What are convertible notes?

Convertible notes are a promissory note with certain conversion features that allow them to be converted into equity of the issuing company. Commonly, the events that happen which trigger the conversion are:

  1. An upcoming equity financing;
  2. An M&A transaction that results in an exit of the issuing company; and
  3. Maturity.

Convertible notes have several other features that can be negotiated by the issuing company and the investor. You can read more about these features and the terms in this user’s guide on convertible notes.

Convertible notes are a hybrid instrument. They have debt-like features and equity-like features. Because of their hybrid nature, they can be used frequently when conventional debt (like a term loan) or simple equity (like common stock) may not be helpful.

Should I Be Using Convertible Notes?

If you are a company founder or executive and you are trying to figure out whether convertible notes are the right instrument for you, here are a few common scenarios when you should be using convertible notes:

  1. You are starting up and you need capital, but you do not want to take on equity capital because you are concerned about dilution.
  2. You need more runway to hit your internal milestones before raising your next round of equity.
  3. You just raised a round of equity capital and investors are interested in offering you more capital, but you are concerned about excessive dilution.

If you are an investor and are trying to figure out whether convertible notes are the right investment for you, here are a few instances you may want to use convertible notes:

  1. You are an angel investor interested in investing in a start-up, but you do not want your investment subordinated to the venture capital fund that you expect will be investing shortly. You would like to invest now but be treated as an equal to the next large investor.
  2. You are a mid-market investor and you would like to invest in a company that is having a tough time making its numbers. You are worried that the company will ultimately sell in a fire sale, but you would like to have exposure in case the company has a significant exit, but if they do not make it, you would like to recover your investment amount.
  3. You would like to invest in a company that has an imminent exit, and you would like to see a more substantial return than what you might charge for interest, and you would like to see your investment returned before any of the investors.

Convertible notes are ubiquitous in the venture capital and early stage investing ecosystem. However, not all convertible notes are the same. If you are thinking about using convertible notes to make an investment or raise money, think about what happens 12-36 months down the road, since the decisions made now can have big downstream consequences.

For more information about convertible notes, you can review our depth resource guide which provides depth of insight about the various terms of convertible notes. You can use this guide when planning and reviewing the terms of your convertible note agreement. Feel free to contact us if you need further guidance about this fundraising option.


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