A convertible note is a form of debt instrument that converts into equity, typically in conjunction with a future financing round. It is treated like a debt instrument until conversion takes place.
It is commonly used to bridge the financing gap, so the company can reach the next successful financing round.
Being a form of debt instrument, its liquidation preference commonly ranks above all other equity classes. This is a large assurance to investors if the company is unable to materialize their expected valuation growth.
How does it impact the cap table?
Typically, they do not appear in a company’s cap table simply because they have not converted, and most cap tables do not account for what happens in the event of a conversion.
This is because it will require the company to construct a scenario analysis to see if the next “theoretical” financing round will trigger an automatic conversion. However, even despite attempting to build the cap table, there is a wide array of possibilities on the liquidation preference, investment amounts and how existing ownership changes.
These factors usually deter companies from trying. Unless, there is an upcoming financing round and all current/prospective stakeholders are interested in the cap table’s outcome.
Under what scenarios will a convertible note convert?
It will either automatically convert at the next successful “qualified” financing round or optionally at times investors can choose to convert at a non “qualified” financing round. Very commonly there is a “Conversion trigger” which stipulates the minimum gross proceeds of the financing round, to trigger automatic conversion.
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