Convertible notes

Sometimes called SAFE notes (Simple Agreement for Future Equity), these are essentially a promise to convert a loan into equity at a future point in time. They have a maturity date which is the target conversion date and being a loan, they include interest (although SAFE notes from accelerators do not have to carry an interest rate) on the principle up to the maturity date (typically less than 10%). In recognition of the risk to the investor they also include a discount off the equity cost at the point of conversion (typically 20% to 30% off).

They are used as a kind of bridging function for very early-stage companies that cannot produce an accurate valuation yet or that don’t want to launch into a full-blown investment round. In many cases though, the valuation cap element sets the future valuation level anyway, so agreeing that cap will likely require a forecast valuation calculation to be made.

An example arrangement might be a 12 month $200k convertible note at 10% interest, 20% discount and a $2m valuation cap. That means in 12 months, if the company is valued at $1m, the $200k + 9% interest investment converts to 27.5% equity in the company. If the company is valued at $2m then it converts to 13.75% equity. Due to the cap, if the valuation exceeds $2m, then the note will not convert to an equity level higher than 13.75%, however as the cap must be disclosed to any new investors at that point, they are unlikely to be happy to invest at a higher valuation than the cap itself – effectively setting a ceiling for the next investment round.

At lower valuations, the note can convert to extremely high equity levels, so a Founder may insist on a minimum. If at the point of maturity, the investor disagrees that the minimum valuation has been met, then they may request that the note does not convert, and that the loan is simply paid out.

Convertible notes are therefore expensive and carry risk. Assess them in the same way you would a loan.