Convertible Notes in Early-Stage Financing

This technical note introduces convertible note financing for early-stage start-up companies. These unpriced securities offer significant advantages related to delayed valuation, greater speed, and lower cost of completion compared to venture capital financing. As a result, the number of early-stage companies raising capital through convertible notes over the past decade has greatly increased. The note discusses the most frequently used terms and arrangements of early-stage convertible notes, the estimation of noteholders' equity ownership from delayed valuation, and the costs and risks of this form of financing to both entrepreneurs and investors. It offers a number of numerical examples that walk students through calculations of convertible note payoffs under different success scenarios and different valuation caps. It also explores how convertible notes affect subsequent equity rounds' pricing. Finally, the note offers statistical data on the state of convertible note issuance. This note is a successor to an older note, "Convertible Notes: A Form of Early-Stage Financing" (UVA-F-1925). The cases "Should udu a Convertible Note?" (UVA-F-2025) and "MedMetric, LLC: Seed-Round Convertible Note Financing" (UVA-F-1924) can be assigned with this note as an application of this form of financing.