What is an investor buying? - Investor is loaning funds to a business by purchasing a promissory note that could convert into equity in the future when the business raises capital again.
How does an investor make money? - Investors are entitled to interest on their investment calculated with a specified interest rate. The interest rate is referred to as an annualized rate, and is typically paid in shares of stock when the note is converted into shares. If the company offers equity at some point in the future, the investor may have the note converted into equity. For example, if $1000 is invested in a convertible note paying 10% annual interest and the company receiving the loan offers equity 1 year later, since the investor would be owed $100 worth of interest after 1 year, the investor is entitled to receive shares of equity worth $1100. The maturity date of the note is the date by which the note must be repaid by the company. Convertible debt may also have a discount rate as a means of rewarding early investors. For example, if an investor invests in a convertible note has a discount rate of 20%, and the next time the company raises capital with a share price of $5, your note could potentially convert into shares of stock at a cheaper entry price of $4. When a note is converted, the investor is now a holder of only some form of equity. The terms of a convertible note can also include a valuation cap. A valuation cap is the highest value for the company that your note could convert into. For example, if an investor buys $1,000 of convertible debt with a $5 million valuation cap, and the company is subsequently sold for $100 million (before issuing additional shares), the original investment could convert into shares at a $5 million valuation, (or 1/20 of the $100 million current valuation) and would yield the investor a profit of 20x the original investment. When a note has a valuation cap and discount rate, typically only one will apply and the one that applies will be whichever one gives the investor the better price.
What are the risks? - The risks with this form of security are similar to those of equity, since the note must be converted before an investor can earn a return, the conditions required for conversion must happen to avoid the loss of investment. If the company is unable to secure funding before the maturity date of the note, there is a risk the company could default on the note. When, and if a note is converted and the investor is given shares of equity in the company, the risks at this point become the same as those relevant to equity investments.
Why issue this? - Convertible notes are typically used by new companies that anticipate raising an equity round of financing in the future and want to delay determining a valuation for the company. Determining a valuation early in a company’s life is difficult and can be very subjective before a company has a reasonable history of revenues. Convertible notes allow the company to avoid the risk of determining a valuation without adequate data.