The most common scenarios are:
(1) The note gets repaid at a premium (principal + interest + premium)
(2) The note gets repaid as an ordinary loan (principal + interest)
(3) The note converts according to its terms
Convertible Notes in a Nutshell
There are two key differences between an ordinary loan and a convertible debt note: (1) the discount, and (2) valuation cap. These features are what change a vanilla loan into convertible debt.
Like ordinary notes, convertible debt notes provide an issuance date, interest rate and maturity date. Unlike conventional loans, repayment is with equity. It’s the valuation cap and discount that motivate investors to take early risks in order to later receive the rewards of strong returns on their investment.
The discount rewards early investors for taking larger risks than later investors by offering them the right to obtain shares at a cheaper price than that paid by Series A investors, once the Series A round closes.
The conversion cap also rewards early investors for their early risk, but in a different way than the discount. The cap sets the maximum value of a company when Series A closes, again giving an advantage to earlier investors.
The discount and cap offer early investors two different ways to value their original investment (the loan) when the Series A round closes with a specified valuation. One method will usually give the investor a higher rate of return than the other.
Convertible notes will commonly specify what will happen in the event that the company is acquired prior to the note’s maturity.
Here’s a breakdown of the most common scenarios:
The Note Gets Repaid at a Premium
This approach tends to align the interests of founders and investors. It provides that investors will receive principal + interest + premium if there’s a change in control by rewarding early investors for the larger risks they were willing to take when the startup had no track record. The premium can range anywhere from .5x to 3x the original investment.
The Note Gets Repaid as an Ordinary Loan
This is the most favorable to founders since it requires only that the company repay the loan plus interest. However, sophisticated investors usually want to be rewarded for assuming high risk early on. Since they wouldn’t be receiving the higher rates of return offered by other options - conversion or repayment with premium - it’s the least likely option. However, if the acquisition price is too low, debt holders can be more inclined to demand repayment and reject any conversion option.
The Note Converts
If the investor negotiated terms that triggers conversion upon the acquisition of a company prior to the qualifying financing round, then the note would convert to equity subject to the specified discount and cap. Essentially, this means that all principal and accrued unpaid interest automatically converts into equity at the maximum conversion price (i.e., whichever option - the cap or the discount - offers the investor the greater rate of return). You can learn more here about how this option works.