Understanding Convertible Notes

Convertible notes are a type of short-term debt that converts into equity. They are often used in early-stage financing because they delay the valuation of the company until a later round when more information is available.

Convertible notes include a principal amount, an interest rate, and a maturity date. Upon maturity or a qualifying financing event, the notes convert into equity, typically at a discounted price to the valuation of the subsequent funding round.

A valuation cap sets a maximum company valuation for converting debt into equity. This protects early investors from excessive dilution if the company's value skyrockets before the conversion event, ensuring they receive a fair equity stake.

Convertible notes can have unexpected tax consequences. For example, if the notes convert into equity at a significant discount, this can be considered taxable income for the investor. Proper tax planning is crucial to avoid unexpected liabilities.

In recent years, SAFEs (Simple Agreements for Future Equity) have gained popularity as an alternative to convertible notes. Unlike notes, SAFEs are not debt instruments and do not accrue interest, simplifying early-stage financing and reducing potential complexities.

Some companies convert notes into equity right before IPOs, leading to sudden and massive equity changes. This can drastically alter investor stakes overnight.