A convertible note is a short-term debt instrument that converts into equity at a future funding round, rather than being repaid in cash. It accrues interest and typically includes a discount rate and/or valuation cap that give the note holder a better price than the next round's investors, compensating for the earlier investment risk.
In Depth
Convertible notes are a popular instrument for early-stage and bridge financing because they defer the valuation discussion. Setting a valuation for a very early-stage company is difficult and often contentious. Convertible notes avoid this by converting into equity at the valuation set by the next priced round, with a discount.
Key terms include: principal amount (the investment), interest rate (typically 6-10% annual), maturity date (when the note must be repaid or converted, typically 12-24 months), discount rate (the percentage discount to the next round price, typically 15-25%), and valuation cap (the maximum valuation at which the note converts, protecting early investors from excessive dilution if the company achieves a very high valuation).
At the next priced round, the note converts automatically. The conversion price is the lower of: (a) the next round price less the discount, or (b) the cap divided by the fully diluted share count. Accrued interest typically converts at the same price, adding to the shares received.
FP&A teams should model convertible notes carefully because the conversion terms affect the cap table at the next round. Multiple notes with different caps and discounts can create complex conversion waterfalls that significantly impact founder dilution.
For UK companies, convertible notes create a debt instrument on the balance sheet until conversion. They are treated as financial instruments under FRS 102 Section 11/12, with the liability measured at amortised cost. Interest is charged to the P&L.
Real-World Example
A UK startup raises £300K via a convertible note: 8% interest, 20% discount, £8M cap, 18-month maturity. After 12 months, the company raises a £3M Series Seed at £10M pre-money. Accrued interest: £24K. Total converting: £324K. Conversion price is the lower of: £10M round price less 20% discount (£8M effective) or the £8M cap — both give £8M. The note converts as if invested at an £8M valuation, giving 20% more shares than Series Seed investors receive per pound invested.
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