What are the terms of a convertible note?
FundraisingConvertible notesEquity
A convertible note is a loan that is designed to be converted into preferred stock rather than repaid. Its terms are the terms of any loan, principal, interest and a date it comes due, plus a set of conversion terms that say when it turns into shares and at what price. The conversion terms are where the negotiation happens, and they look almost exactly like a SAFE's: a valuation cap, a discount, or both. What a note adds is the debt, and the debt is what gives the investor leverage a SAFE does not.
The loan terms
Principal is the amount invested. Interest accrues on it, usually simple rather than compounding, often at a modest rate in the 4 to 6 percent range for early rounds rather than the 6 to 10 percent that was once typical, because the interest converts into extra shares and so acts as a second discount. A note that charges no interest at all can create tax and accounting problems, so a low rate is the normal answer rather than none. The maturity date is when the note comes due if nothing has converted it, commonly 18 to 24 months out. A later date is better for the company. Most notes let a majority of the holders extend it, and most are extended or converted rather than called.
The conversion terms
A note converts automatically in a qualified financing, meaning a priced round that raises at least a stated amount of new money, often one to two times the notes outstanding. The floor stops a company forcing conversion with a token round. On conversion the investor's principal and accrued interest buy the same preferred stock the new investors buy, at the lower of the discounted round price and the price implied by the cap. A 20 percent discount on a $1.00 round price is $0.80. A $5 million cap on a round priced at $10 million is half price. The investor gets whichever is better for them, not both.
Pre-money and post-money caps
Caps used to be pre-money: the note converted at a price based on the cap divided by the shares outstanding before the round, and every note diluted every other note. Many notes written today follow the SAFE and use a post-money cap, under which each investor's percentage is fixed at investment divided by cap and does not move as more notes are sold. Read the definition of the conversion price to see which yours is, because the difference decides who bears the dilution: under a pre-money cap the note holders share it, under a post-money cap the founders carry all of it. The same words, pre-money and post-money, also describe the valuation of the priced round itself, and the two uses need keeping apart.
How a note differs from a SAFE
A SAFE is not debt. It has no interest, no maturity date, and no right to be repaid on a day. A note has all three, and they are the reason an investor might insist on one: a maturity date is a lever to force a conversation, interest is a small extra return, and debt sits ahead of equity if the company fails. A note also goes on the balance sheet as a liability and needs a board consent like any borrowing. In a friends and family round the note is often chosen for a different reason, that the paper looks like a loan to someone who has never bought stock. Everything else, the cap, the discount, the conversion into the next round's preferred, is the same idea in both.
Arabella's library note uses a pre-money valuation cap with a discount, with a questionnaire that fills the cap, the discount, the rate and the maturity date, and a convertible note term sheet for agreeing the terms first.
Related questions
Written by the lawyers who built Arabella. This is legal information, not legal advice for your situation, and reading it does not make us your lawyers. For a real dispute or a high-stakes decision, talk to a licensed attorney. More questions.