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What is a Convertible Note?
A convertible promissory note is a debt instrument that contains provisions where the debt may convert into equity. The following key terms of note are typically found in a convertible promissory note transaction:
- Principal
- Interest Rate
- Maturity Date
- Next Equity Financing definition
- Discount
- Valuation Cap
As an example, a company could receive $25,000.00 (Principal) with an 8% interest rate compounded annually (Interest Rate) via a convertible promissory note. As a part of the deal, the company may agree to repay the debt after 18 months (Maturity Date) unless there is a later financing round of at least $1,500,000 (Next Equity Financing).
If the company closes a next equity financing financing before the maturity date, then the debt would converts into shares of stock sold at the next equity financing. The price at which the debt converts will be the lesser of (i) 80% of the issue price of the stock sold in the next equity financing (Discount), or (ii) a price per share equal to $4,500,000 (Valuation Cap) divided by the total number of shares outstanding immediately prior to the
The reason a discount and/or a valuation cap is included as part of the transaction is the company can incentives early stage investors to invest by providing a benefit for taking on early stage risk.
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