Convertible Notes and Convertible Bonds

What are Convertible Notes and Convertible Bonds?

Both instruments are debt that can convert into equity. However, their common usage contexts define their differences:

• Convertible Note (Startup / Early-Stage Context):
  • A short-term debt instrument issued by early-stage, private companies (startups).
  • It's designed to provide quick bridge funding without establishing an immediate valuation.
  • Typically converts into equity (often preferred shares) at a later financing round, usually with a discount or valuation cap.
• Convertible Bond (Established Company Context):
  • A fixed-income corporate debt security issued by more established, often public companies.
  • It functions like a traditional bond (paying interest and having a maturity date) but gives the bondholder the option to convert it into a predetermined number of the issuer's common shares.
  • Used to raise capital at potentially lower interest rates than conventional bonds, with the equity conversion offering upside to investors.

Key Terms of Convertible Notes (Startup Focus)

These terms are central to how startup convertible notes function, particularly regarding conversion:

1. Principal Amount: The initial sum of money loaned by the investor to the company.
2. Interest Rate: Accrues on the principal (e.g., 2-8% annually) but typically doesn't get paid in cash. Instead, it adds to the principal amount that converts into equity.
3. Maturity Date: A specified date (e.g., 12-24 months) by which the note must either convert or be repaid. If a qualifying equity round hasn't occurred, the company may need to repay the debt, or the note might convert at a pre-agreed (often lower) valuation.
4. Conversion Discount: An incentive for early investors. When the note converts, the investor receives shares at a discounted price (e.g., 10-25% off) compared to what new investors in the triggering equity round pay.
   • Example: If new investors pay $1.00/share and the note has a 20% discount, the noteholder converts at $0.80/share, getting more shares for their money.
5. Valuation Cap: A crucial term protecting early investors from excessive dilution. It sets a maximum valuation at which the note converts, regardless of a higher valuation in the future equity round.
   • Example: A $100,000 investment with a $5M cap. If the next round is at a $20M valuation, the investor's $100,000 converts as if the valuation were $5M, securing a larger percentage of the company. The investor converts at the lower of the valuation cap or the actual pre-money valuation of the next qualified financing.
6. Qualified Financing: A specific future equity funding round (defined by a minimum capital raised) that triggers the automatic conversion of the notes.
7. Liquidation Preference: While debt first, some notes might have provisions for a liquidation preference if the company is acquired or dissolved before conversion.

Key Terms of Convertible Bonds (Established Company Focus)

These terms define how convertible bonds operate in the public or larger private markets:

1. Par Value (Face Value): The amount the bondholder will receive at maturity if the bond is not converted.
2. Coupon Rate (Interest Rate): The fixed annual interest paid to bondholders. This rate is typically lower than on non-convertible bonds because of the added value of the conversion option.
3. Maturity Date: The date when the bond principal is due to be repaid if not converted.
4. Conversion Ratio: The fixed number of common shares a bondholder receives for each bond converted. This is typically set at the time of issuance.
   • Example: A bond with a $1,000 par value and a conversion ratio of 20 means it can be converted into 20 shares of common stock.
5. Conversion Price: The effective price per share at which the bond converts. It's calculated as the bond's par value divided by the conversion ratio ($1,000 / 20 shares = $50 conversion price in the example above). This is typically set at a premium to the stock's market price at issuance.
6. Conversion Premium: The percentage by which the conversion price exceeds the stock's current market price at the time the bond is issued. This reflects the value investors place on the equity option.
7. Call Feature: Many convertible bonds are callable by the issuer. This means the company can force conversion or redemption if the stock price rises significantly above the conversion price (e.g., 130% for a sustained period), allowing the company to eliminate the debt obligation and force dilution.
8. Put Feature: Less common, but some bonds allow the bondholder to force the issuer to repay the loan at an earlier date, usually if the stock price performs poorly.
9. Call Protection Period: This is an initial period after the bond is issued, during which the issuer cannot call the bond, regardless of how high the stock price rises.

Who Uses Convertible Notes and Convertible Bonds and Why?

The context of use is where these two instruments diverge, reflecting their tailored advantages for different entities:

Convertible Notes: Primarily for Seed and Early-Stage Startups

• Scenario: Companies with a compelling idea, a prototype, or early traction, but limited revenue or a clear valuation. They need runway capital to hit milestones before a larger, priced equity round.
• Why they use them:
  • Deferred Valuation: Startups often lack the operating history to justify a firm valuation. Convertible notes allow them to get money quickly without a potentially contentious or undervalued pricing discussion.
  • Speed and Simplicity: Quicker and less expensive to close than priced equity rounds due to simpler legal documentation and less due diligence.
  • Flexibility: Can be issued on a rolling basis to multiple angel investors or early VCs, making fundraising more agile.
  • Retained Control: Founders maintain full control until conversion, as noteholders are lenders, not shareholders.
• Example: A nascent AI software startup needs $750,000 to hire key engineers and develop their beta product. Instead of spending months negotiating a valuation, they raise funds via convertible notes with a $6 million valuation cap and a 15% discount. This allows them to focus on product development and market validation, pushing the valuation discussion to their eventual Series A.

Convertible Bonds: For Established, Often Public Companies

• Scenario: More mature companies, ranging from mid-sized private firms to large publicly traded corporations, seeking to raise capital while managing their debt load and potentially leveraging future stock appreciation.
• Why they use them:
  • Lower Interest Rates: Companies can often issue convertible bonds with a lower coupon rate than conventional bonds because investors accept less interest in exchange for the potential equity upside if the stock price rises. This reduces cash interest payments.
  • Deferred Equity Dilution: They raise capital without immediately diluting existing shareholders. Dilution only occurs if (and when) the bonds convert. This can be strategic for managing Earnings Per Share (EPS).
  • Flexibility in Capital Structure: Offers a hybrid financing option that can be attractive when stock prices are volatile, or when the company wants to signal confidence in its future growth.
  • Refinancing Debt / Acquisitions: Can be used to refinance existing debt, manage the company's balance sheet, or fund acquisitions, providing a flexible means to raise large sums of capital.
• Example: A publicly traded pharmaceutical company requires $500 million for a major R&D project. Instead of issuing straight debt (which might demand high interest) or pure equity (which would dilute shareholders immediately), they issue convertible bonds. This allows them to secure funding at a lower interest cost, and if their R&D is successful and the stock price rises, the bonds may convert, effectively turning debt into equity, which strengthens their balance sheet. A well-known past example includes Tesla using convertible senior notes to raise capital while benefiting from lower interest rates given their growth trajectory.

Convertible Notes vs. Other Funding Methods

• Vs. Equity Funding (Priced Round):
  • Convertible Notes: Faster, simpler, no immediate valuation, less founder dilution initially, fewer investor rights.
  • Equity Funding: Establishes clear valuation and ownership from day one, provides defined investor rights (voting, board seats, anti-dilution), and no repayment obligation. More complex, time-consuming, and expensive.
• Vs. SAFEs (Simple Agreement for Future Equity):
  • SAFEs: Invented by Y Combinator, SAFEs are not debt. They have no interest rate or maturity date, making them even simpler and more founder-friendly than convertible notes. They only convert to equity upon a financing event or exit.
  • Convertible Notes: Are debt instruments, with interest and a maturity date, offering slightly more traditional lender protections to investors.
  • Choice: SAFEs are often preferred for very early (pre-seed) rounds due to their extreme simplicity, while convertible notes might be used for slightly later seed rounds or bridge financing where some debt-like features are desired.

Conclusion

Convertible notes and convertible bonds, while sharing a fundamental mechanism, serve distinct strategic purposes across the corporate lifecycle.

Convertible notes are the fuel for early-stage innovation, offering startups a fast, flexible path to capital without getting bogged down in premature valuation debates.

Convertible bonds provide established companies with a sophisticated tool to optimize their capital structure, reduce borrowing costs, and manage dilution, offering investors a unique blend of income and equity upside.