Convertible Note Interest Rate: Everything You Need to Know

A convertible note is a financial instrument that is recognized as a hybrid of both debt and equity. Basically, it is a form of a debt instrument with a time-dependent conversion which can be converted into equity by the note holder. In basic terms, a convertible note is an alternative financial tool that allows a debt to be converted into equity after a certain period. However, you might wonder what does interest rate on a convertible note mean. How does it work? And what does the interest rate indicate on the convertible note? Well, this article will help you understand the concept of convertible notes and their interest rate.

Convertible note interest rate

Before we proceed to explain convertible notes and their interest rate, let us first understand the concept of interest. In financial terms, interest is the fee charged by a lending institution to use its capital to meet the borrower’s requirements. Convertible notes are designed so that debt is generally converted into equity after the maturity date.

While convertible notes are essentially debt instruments, however, they do not collect interest as most other loans or debt instruments. Instead, the interest on convertible notes continues to accrue till the time the conversion from debt to equity is completed or is paid in cash. So, the convertible note interest rate is the interest rate on a convertible note that continues to accrue until the maturity date.

What is a convertible note?

Convertible notes are a type of financing instrument which startups and small businesses use as a part of their funding. In simpler terms, this is a financial agreement or short-term debt contract between the investor and the company whereby the debt note is converted into equity after a certain period. Generally, the conversion from debt to equity takes place in conjunction with a triggering event i.e. future funding rounds. The debt on a convertible note has a specific maturity date (usually one year) after which the debt would be converted into equity. Therefore, the company can raise funds using a convertible note.

How does convertible note work?

In general, when an investor provides funds to a company, they expect a return on their investment in the form of a profit, equity or other benefits. To make it simple, convertible notes are issued to the investor in return for the funding provided to the company. The convertible notes work in a way that equity is issued to the investor instead of paying interest or principal amount, however, this conversion takes place after a predefined time. Valuation caps and discounts are applied during the conversion from debt to equity to protect the potential of future funding and ensure that the company’s ownership is diluted under control.

Benefits of using a convertible note

As discussed above, convertible notes tend to be seen as a hybrid of debt and equity. They provide benefits to the company for raising funds. Here are some of the benefits of using convertible notes:

• After the subsequent financing round, convertible notes can be converted into equity easily. As a result, valuation at the time of issuing convertible notes is not required, which is beneficial, especially for businesses in their early stages.
• Convertible notes can be issued and executed in less time with fewer negotiations and with lower legal fees. In this way, convertible notes provide startups with a quick and cost-effective way to raise funds.
• Issuing convertible notes do not provide voting rights to the investors on corporate affairs. So, in case of any issues or disputes, it is less likely that the investors would be able to influence the decision, thus reducing the risk for the startup and management.

Risk of using a convertible note

Convertible notes may seem to be a great way of raising funds, however, there are some risks associated with them. Below mentioned are some of the prominent risks with convertible notes:

• The provisions of convertible notes can be tricky to interpret. In this regard, a state lending law is applicable in almost every state in the US. However, it is recommended to check the rules and regulations based on the state in which the convertible note is issued.
• Constant issuance of convertible notes can be a potential risk to a business because it poses a risk for failure of repayment, decreases the value of equity, increases the level of dilution and so on.
• In some cases, potential investors may not provide a good valuation, which can be problematic for the company because the conversion from debt to equity takes place after the next financing round when the valuation is determined.

What does the interest rate indicate on a convertible note?

Well, convertible note interest rate typically indicates the amount of interest that is accrued until the maturity date of the convertible notes i.e. before the conversion or by paying cash. In this regard, the convertible note interest rate often ranges from 2% to 8% depending on the amount of the debt note, financing amount, terms, and so on. To better understand the mechanism of convertible note interest rates, let us look at a simple example. For instance, with an interest rate of 8%, $100 invested on the first day would convert to $108 invested on day 365 if the conversion occurs on day 365.

Important considerations for convertible interest rate

Now that you have a basic understanding of convertible note interest rates, it is important to look into some of the key aspects that are associated with it. Below mentioned are some of the considerations for convertible note interest rates:

• The rate of interest should not be lower than the federal rate. If this takes place, the note may be considered to have an original issue discount. This is covered in IRC Section 1272. (a).
• When a convertible note converts to equity, the interest is converted into preferred stock instead of paying interest in the form of cash.
• As mentioned earlier, the interest will continue to accrue on a convertible note until the conversion from debt to equity takes place.
• In coastal areas, the interest rate is typically lower. On the other hand, in the middle parts of the country, the interest rate tends to be higher.
• As per usury laws, there is a maximum limit of interest rates that can be charged from a borrower (company) annually. It is better to check the laws in the state where you are located.

Convertible note terms

To get a more thorough knowledge of convertible notes, it is important to look into some of the essential terms that are associated with convertible notes. The following are some of the most important convertible note terms:

• Valuation cap – As a matter of fact, the convertible notes are converted to equity after the next funding round when the valuation is determined. So, the valuation cap sets a limit on the company’s valuation so that the note can only convert at the agreed-upon valuation cap.
• Convertible note size – Essentially, the size of the convertible note signifies the amount of money that can be raised from a single investor. In this regard, the size of the convertible notes typically ranges from $50K–$100K, making it a good option for startups.
• Discounts – As we know, convertible notes are converted into shares or equity. The discounts are used to compensate for the price of the shares offered to the investors. As such, discounts can be used by investors to obtain shares at lower prices.
• Maturity date – The last date when the convertible note can be converted into equity is called the maturity date. The maturity date of a convertible note is significant as it indicates the period when the holder will get a return.
• Interest rate – The interests on convertible notes are payable in the form of equity. As discussed, the interest rate is accrued continuously until the conversion from debt to equity happens.
• Pre-money valuation – The funding amount determined before the next financing round, which serves as the conversion trigger by determining how much equity the company will get in that round. The convertible security is converted as a result of the conversion trigger.

How to use Eqvista’s financial modeling tool to calculate convertible notes?

Eqvista provides a financial modeling tool that helps startups calculate, analyze and compare the financial and other key metrics of a convertible note. With the help of this tool, you can effectively determine the value of convertible notes. Here are the two ways you can use Eqvista’s financial modeling tool to calculate convertible notes:

• Round Modeling – When convertible notes are issued or new investments are made in the firm, round modeling, a financial technique, helps to estimate how the cap table of the company will be diluted. This data aids the business in making crucial financial decisions including new investments and convertible note issuance. Additionally, the tool would serve as a convertible note calculator, providing the results of the cap table after all instruments have been converted.
• Waterfall Analysis – Oftentimes, companies use the waterfall analysis tool to help them create financial models that show how much money each shareholder would receive after the company exits. Complex computations are performed on the model for each sort of shareholder. It shows each situation that could result in a company’s exit. As a result, startups can use this tool to calculate the value of convertible notes.

Manage your convertible notes with Eqvista!

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