5 Key Terms of Convertible Notes

The 2 primary documents for most convertible debt seed rounds are the Note Purchase Agreement and the Note. The Note Purchase Agreement is signed by the company and each of the investors and will contain the general terms of the financing round (such as the maximum amount raised and the time period the company has to raise the round), as well as representations from the company (e.g. the company is in existence and has authority to issue the notes) and from the investors (e.g. they are accredited). The note is the IOU from the Company (saying they owe the investor x amount of money to be paid back in cash or in equity upon certain events. Here are the key terms you will typical see in the note:

1. Interest Rate. The typical range for interest rates is 6-8%, but I have been seeing several deals using the Fed Funds Rate, which is currently around 0.25%. Obviously the company prefers the lowest rate possible.

2. Conversion. The note will include the terms upon which the note will convert into equity. Typically, a note converts into equity upon the next round of institutional financing (usually the Series Seed or Series A Preferred Stock round). Also, upon a Change of Control (sale/merger of the company), the note will be repaid (at either the outstanding principal amount or some multiple of the outstanding principal amount (e.g. 2 times) plus accrued interest). Some notes will permit the holder to convert into equity upon a Change of Control as well.

3. Discount/Valuation Cap. Often notes will convert at a discount (commonly around 20%) to the price per share of the next equity round and sometimes there is a valuation cap, often ranging from $6-8 million, which sets an upper limit on the conversion price. This makes the note offering more attractive to investors who are coming in at a risky time.

4. Prepayment. The note will include terms of prepayment. Virtually always any prepayment requires the approval of a majority of the investors. The reason for this is to protect their conversion rights. Otherwise, the company could simply elect to repay the note instead of converting it if a financing or other event is upcoming.

5. Maturity. The note will include a date upon which the company must repay the note. The typical term is anywhere from 1-2 years. Occasionally, a note may include an option on the part of the investor to convert the note into equity upon maturity, but I don't see this often.

There are numerous variations in convertible debt financings. I have highlighted what I commonly see, but every deal is different depending on the type and stage of the company and the nature of the investors. Understanding the general terms should help you better negotiate the right financing terms for your particular offering.