A convertible note is an unsecured loan that converts to stock at some point in the future.
Convertible notes have a rich history in early-stage investing and are one the most popular forms of startup investing securities.
A particularly useful feature of convertible notes is that they allow both companies and investors to delay setting the price on a company’s value.
This is important with new space startups because many of them are pre or low revenue companies. Since revenue is often used to determine a company’s value, setting a price without it can be arbitrary and open to debate.
With convertible notes,the number of company shares investors receive is determined at the next qualified financing (typically when $1 million or more is raised), when venture capitalists set the price of the company. Investor shares will be calculated and converted to stock using a company’s Valuation Cap, Discount Rate, and Interest Rate. At this time, earlier investors will receive a better price than the later investors as a reward for their earlier investment, and the increased risk they took on to make these investments.
If a startup does not raise another round of funding after issuing a convertible note, the note becomes due at the maturity date, typically in 18-24 months. Convertible notes are rarely repaid in cash and usually convert to equity at a pre-set target price.
The Discount and Interest Rates have a relatively minor impact on future returns when dealing with convertible notes. The most important term to focus on is the Valuation Cap because this can greatly impact the price of an investor’s future shares. For early-stage space companies, this is usually set between $5 to $20 million.