Frequently Asked Questions > Starting a Web Company > What is a convertible note?
It’s a financing instrument that allows you to raise money in the form of a note (loan with an interest rate). However, instead of paying interest current and paying it back at the end of the term, it gets converted to equity at a certain point (trigger event) at a discount to (typically) the current valuation of the company (conversion discount) or at some set value (value cap).
I.e say you raise $1,000,000 in a convert. You have 1,000,000 shares outstanding when a trigger event happens (sell company, raise more money, end of term). Let's say at that moment your company is valued at $5 million (you sell for that much or the new investor is buying shares at that price ~ $5 / share). Let's say the conversion discount is 20%. Without the discount, your $1,000,000 investor would get to buy $1 million / $5 = 200,000 shares. With the discount, they'd get $1 million / $4 = 250,000 shares. So it behooves you to get that value up. There's also accrued interest that factors in to their total conversion price, but you get the general idea.
I'm sure someone much smarter than I am has a more intricate explanation. Let me know if you find one and I'll link to it.
Last updated on January 30, 2011 by CampbellM
