First-time Entrepreneur’s Guide to a Convertible Note

My friend Tim from Cleveland called me to day and wanted a quick overview of how convertible notes work.  They’re pretty simple if you understand a few basic points.

First, use of this security is a way to avoid having to agree on a value for your business today.  What the investor/lender is really saying is “I’ll give you the money now and we agree that it will buy shares later when someone else comes in and establishes the price.”

Second, by giving you some money now, as opposed to waiting until everyone else ponies up, they’re taking more risk and are generally rewarded with a lower price per share, either via a straight discount or warrants to purchase more shares, plus interest at a reasonable rate.

Third, these notes generally include a mandatory conversion feature that says “if you raise a minimum of x dollars, I agree to convert my loan into shares of the round.”  If the note didn’t include such a feature, the lender could demand repayment which might enable her to take control of the company or at least its assets.

Most frequently, the term is one year but shorter or longer terms may be used depending on the circumstances.  Investors rarely want to own the companies they lend to so extensions are not uncommon.

But own them they can, potentially including valuable intellectual property so caveat borrower.  And get a good lawyer.


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