A convertible note is an investment vehicle often used to facilitate investing in a company establishing a valuation. This may be desirable for many reasons, including efficiency or the particular business stage (too early to attract money at an acceptable valuation or a need for cash at a point when a valuation inflection point is on the horizon).
Convertible notes are debt instruments, but most convert into equity at a later date at a conversion price that usually is subject to a conversion price discount and/or a conversion price cap. The terms of conversion typically provide that the principal amount of the note converts automatically into equity in connection with the company’s next financing, but there may be an established “minimum size of that financing to trigger automatic conversion. Additional customary terms include optional conversion if the automatic conversion terms are not met, possible conversion or premiums on a change of control, and interest.