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What is a convertible note?

Definition: Convertible note is a type of seed investment in the form of a loan (short-term debt) that can be converted into equity in the future. The investors loan money to a startup, and instead of getting their money back with interest, they receive equity in the company based on the terms of the note.

Convertible notes are attractive both to investors and founders because they don’t force them to determine the value of the company, since there might not be any at the moment, and because they offer flexible financing options and the potential for a higher ROI if the startup is successful.

The terms of a convertible note are flexible and negotiated between the company and the investor. 

Convertible note example

Let's consider a hypothetical scenario where a startup called "NewXYZ" has raised $500,000 in seed funding through convertible notes. 

Here's how the conversion into equity can look:

Conversion trigger: The terms of the convertible note specify that the notes will convert into equity if the company raises a new round of financing (Series A round). NewXYZ is now in a position to raise a Series A round of $5 million at a pre-money valuation of $20 million.

Conversion price: The conversion price of the convertible note is set at a 20% discount to the Series A price per share, which is $1.25. This means that each $1 of the convertible note will convert into $1.25 of equity.

Conversion calculation: To calculate the number of shares that each convertible note holder will receive, the $500,000 in convertible notes is divided by the conversion price of $1.25. This results in 400,000 shares of NewXYZ stock.

Conversion into equity: The convertible notes are converted into equity and the convertible noteholders become equity holders of NewXYZ. The 400,000 shares of NewCo stock that were issued to the convertible noteholders represent a 2% ownership stake in the company.

Post-conversion capitalization: After the conversion, the post-money capitalization of NewXYZ looks like this:

Common Stock

$20 million * 100% = $20 million

Preferred Stock (Series A)

$5 million / $1.25 (Series A price per share) = 4 million shares

Convertible Notes

$500,000 / $1.25 (conversion price) = 400,000 shares

This is an example of how the conversion of convertible notes into equity might look in a hypothetical scenario. The actual terms and conditions of each convertible note will vary, and the conversion process can be more complex.

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Article FAQs

Why are convertible notes used?
Early-stage startups can’t get valuations, and with that, they can’t get equity funding. Convertible notes allow those startups to get seed funding and achieve a more substantial base for valuation before the Series A funding round begins.
Is convertible note debt or equity?
A convertible note is a hybrid of debt and equity. They are considered debt because they have a maturity date and an interest rate, and the company must repay the funds to the investor. But, they also have an equity component because they give the investor the right to convert the debt into equity, typically when the company raises a new financing round.

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