Understanding convertible notes in startup financing

Convertible securities are a popular financing tool for early-stage startups, offering the flexibility to raise capital without immediately setting a company valuation. These instruments are particularly valuable because they adapt to different stages of a company’s fundraising journey. 

Since 2020, 60.2% of convertible securities issued after a priced round have been identified as convertible notes, according to Aumni market data, while SAFEs (Simple Agreements for Future Equity) accounted for the remaining 39.8% of convertible securities during this period. 

This distribution highlights how convertible notes are frequently used in these scenarios due to their structured approach, offering features such as interest rates, maturity dates, and potential discounts at conversion. SAFEs on the other hand are often chosen for their simplicity and flexibility, particularly in earlier fundraising stages.

This brings us to a fundamental question: what exactly is a convertible note and how does it work in practice?

What is a convertible note?

A convertible note is a debt instrument that is intended to convert into equity at a future company event, typically when the startup raises its next round of capital. Unlike traditional debt, generally a startup’s intention isn’t to repay the loan, but to incentivize investment in between priced rounds and convert investors to a formal equity position once the note converts to shares. The conversion mechanics are predetermined terms, including discount rates and valuation caps.

Convertible notes offer two primary advantages. First, they provide quick access to capital without the complexity of a traditional priced equity round (e.g. registering shares, marketing, roadshows). Second, they allow startups to defer valuation to a later round, providing protection from being mis-valued during times of macro or business uncertainty.

‍Key Terms

Interest Rates

While convertible notes are generally meant to convert into equity, they still accrue interest until the conversion happens. This ensures investors earn returns even if the company delays its next round of financing, as has been the case since 2022.

Aumni’s data shows a steady increase in average convertible note interest rates  climbing from 5.9% in January 2019 to 9.5% in May 2024 before its decline in Q3 to 7.5%.

Interest rates on convertible notes typically mirror by broader economic conditions, such as Federal Reserve policy. For example, when the cost of capital is high, convertible note interest rates may rise, reflecting higher borrowing costs. When the Fed lowers rates, note interest rates could stabilize or decrease, potentially creating a more favorable environment for startups.

Startups generally prefer lower rates to keep financing costs manageable, while investors may seek higher rates for better returns. In lower-rate environments, investors might prioritize other terms, like valuation caps and discounts, to achieve their goals.

Discount Rate

Discount rates represent one of the key incentives for convertible note investors. By offering a discount to the next round's valuation, startups can attract capital between traditional funding rounds. Here's how it works: 

If a startup raises its next round at $2 per share, an investor holding a convertible note with a 20% discount would convert at $1.60 per share. A hypothetical $100,000 investment would convert to 62,500 shares, whereas a new investor coming in on the priced round would only receive 50,000 shares for the same amount, increasing pro forma ownership for the former investor.

Most of the convertible notes in Aumni’s dataset have a discount of 20%, with trends showing relative consistency over the years. 

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Valuation cap

The valuation cap is a maximum price per share at which the debt converts to equity, protecting investors from excessive dilution if the startup raises a priced round at high valuation. This, again, incentivizes investors to participate in a capital raise between priced rounds by increasing pro forma ownership relative to capital contributed. Modeling different scenarios around terms like valuation caps can help investors and startups gauge potential impacts before the next financing round.

According to Aumni’s data, most convertible notes include either both a valuation cap and discount or only a discount while notes with only a valuation cap are less common.

‍Convertible notes vs. SAFEs

While both instruments help startups raise capital, they serve different needs. Unlike convertible notes, SAFEs are not debt instruments, are typically simpler to execute, and often contain fewer investor-friendly provisions, such as accrued interest or legal rights, making them particularly attractive for earlier stage startups. Convertible notes offer a more structured approach with additional protections which often appeal to investors.

Ultimately, the choice between convertible notes and SAFEs depends on the specific needs of the startup and its investors. Company stage, investor preferences, market trends, and timing requirements are just a few of the factors considered when deciding on an appropriate convertible instrument.

Regardless of the chosen instrument, staying informed on market trends is essential to structure favorable deals. Aumni gives the insights you need to make decisions with confidence. 

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