Convertible Notes Defined and Why They are Used
What is a convertible note?
The word note is a generic term for debt security. For example, 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 note holder will decide to convert the note into common stock around a liquidity event or at the loan's maturity.
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 the 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, if the business thrives and increases in value, the lender can participate in the upside of growth by converting that debt into stock.
Some investors like convertibles because they provide a safer investment method than buying shares but still have the potential for additional 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 upside potential. In addition, this approach 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 converting to equity, making their finance cost 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. As a result, every deal will be slightly different.
If you are seeking new ways to fund the growth of your SaaS company, talk to us and start the conversation with our finance experts to see whether an Element SaaS Finance loan is right for your business.