What is a convertible note?
The word note is a generic term for a debt security. A convertible note is a debt security that can be converted into common stock at an agreed upon price.
Most often, the lender chooses when this conversion option is executed. Usually, the holder of the note will choose to convert the note into common stock around a liquidity event or at the maturity of the loan.
A company takes a five-year, interest-only convertible note for $100,000. At 10% interest, the company pays $50,000 over the course of the five years. The holder can then choose to convert the remaining $100,000 balance into common stock at the agreed upon price per share.
If the company’s shares are worth more than the price written in the note agreement, the shareholder will have additional earnings. They may even choose to hold the stock longer in the hopes the company continues to grow.
Because of the endless potential for upside after conversion, the interest rates of convertible notes are typically much lower than straight debt.
Why lenders use convertibles:
In an event of default, a convertible note is debt and will get paid back before the equity holders. That makes it a safer investment than equity.
However, the lender can participate in the upside of growth by converting that debt into stock if the business thrives and increases in value.
Some investors like convertibles because they provide a safer investment method than buying shares but still have the potential for extra upside upon conversion.
Why companies use convertibles:
Firstly, lenders can be more competitive. Convertibles allow them to offer lower interest rates or deferred interest payments—thanks to the reduced risk and higher potential for upside. This frees up short term cash for the company because it reduces the size of their repayments.
Secondly, diluting the company in the future is often less expensive than diluting the company now. Of course, this depends on the price per share in the agreement between the borrower and lender. In general, existing shareholders will dilute themselves less by agreeing to a price higher than the company’s current valuation.
Lastly, they may be confident they can repay all or most of the debt before the conversion to equity—making their cost of finance relatively low. This is dependent on the terms written in the contract. Most likely, the lender will have to agree to allow for early repayment.
Convertible notes are a commonly used investment method, but the terms will vary depending on the investors and company involved. Every deal will be slightly different.