Convertible note

A convertible note is an unsecured loan that converts to stock at some point in the future. They are one the most popular forms of seed-stage startup investing because of their history, although the SAFE is rapidly becoming more prevalent. Convertible notes are also useful because they delay the difficult task of figuring out how much the startup is worth. The number of shares you receive is determined at the next qualified financing (typically $1 million), when venture capitalists set the price for preferred stock. Then, calculated by using the Valuation Cap, Discount Rate, and Interest Rate, your loan converts into shares at a lower price than the venture capitalists paid, since you invested earlier. If the startup does not raise another round of funding, the note becomes due at the maturity date, typically in 18-24 months. Convertible notes, however, are rarely repaid in cash. Instead, the note usually converts to equity at a pre-set target price. The discount and interest rates have a relatively minor impact on future returns. The most important term to focus on – which can greatly impact the price of your future shares – is the Valuation Cap. This is usually set between $3 to $20 million, depending on how "hot" the startup is. ## Interest rate on convertible notes Convertible notes also carry an interest rate. Unlike traditional loans, however, this interest is paid in additional shares upon conversion of the note instead of cash. Let’s say you invest $1,000 in a startup through a convertible note with a 5% interest rate. If they receive a series A investment one year later, you would have accrued $50 worth of interest and would be entitled to $1,050 worth of shares at the appropriate conversion rate. While Convertible Notes have an interest rate, the interest and principal are rarely repaid in cash; rather, the accumulated interest entitles the investor to receive more stock if and when the note converts to equity.