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How do convertible notes work?

When you invest through a convertible note the startup receives the money right away, but the number of shares you are entitled to is determined during its next round of financing. At that point the company will have some operating history to determine a fair price, and your loan converts into shares at a discounted price, to reward you for the additional risk you took on by investing early.

Here are a few key terms to know:

  • Discount Rate: The discount rate establishes how much you will be compensated for the additional risk you take on by investing in a company earlier. For example, if you invest using a note with a 20% discount rate, and the next round of investors invest at a valuation of $1 million, your note will convert into equity as if the valuation was $800k, meaning you receive more shares than someone investing in the new round at the price of $1 million.
  • Interest Rate: Convertible notes are technically loans so they also carry an interest rate, although interest is not paid until the note convert, at which point it is added to the amount you invested in order to calculate the number of shares you receive. So if you invest $1,000 through a convertible note with an 8% interest rate, and the next round of financing is one year later, you would have accrued $80 worth of interest and would be entitled to $1,080 worth of shares at the appropriate conversion rate.
  • Maturity Date: The note’s maturity date determines when the note is due and payable. If the business does not have another financing round before then, the convertible note will either automatically convert into a set number of shares, or the business will need to pay back the investors immediately. This will be determined in the Offering Materials for that particular offering.  
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