Convertible Note Terms: When To Speak With An Attorney

Raising capital is a major milestone for any US startup, but the pressure to secure funding quickly can lead founders to overlook crucial details. Convertible notes are a popular early-stage fundraising tool, but the terms you agree to can have lasting effects on your company's ownership, investor relationships, and future fundraising. Many founders sign convertible notes without fully understanding the legal and financial implications, or they assume all notes are standard. This can result in unexpected dilution, unfavorable conversion events, or even legal disputes. This guide explains what convertible note terms mean, highlights common mistakes, provides practical examples, and details when it is especially important to get legal advice before signing.

What Is a Convertible Note?

A convertible note is a type of debt instrument that allows investors to loan money to a startup, with the expectation that the loan will convert into equity (ownership in the company) at a later date, usually during a future financing round. Instead of repaying the investor in cash, the note converts into shares, often at a discount or with other preferential terms. This structure is attractive because it delays the need to value the company and speeds up the fundraising process.

Key features of convertible notes include:

• Principal Amount: The amount of money invested by the note holder.
• Interest Rate: The rate at which the note accrues interest until conversion or repayment. Typical rates range from 4% to 8% per year, but can vary.
• Maturity Date: The date when the note becomes due. If the note has not converted by this date, the investor may demand repayment or renegotiate terms.
• Conversion Terms: The conditions under which the note converts into equity, including discounts, valuation caps, and triggers.
• Qualified Financing: The type and size of future financing round that triggers conversion.

Convertible notes are typically documented in a note purchase agreement and related documents. While there are standard templates, the details can vary significantly between deals and investors.

Example: Suppose a founder raises $100,000 through a convertible note with a 20% discount and a $3 million valuation cap. When the company later raises a Series A at a $5 million valuation, the note holder's investment converts into equity at the lower of the discounted price or the price based on the valuation cap, giving them more shares than new investors at the Series A price.

Key Convertible Note Terms to Review

Understanding and negotiating the specific terms in your convertible note is essential. Here are the main terms founders should review and discuss with investors:

• Discount Rate: This gives note holders a lower price per share than new investors in the next equity round. Typical discounts are 10% to 30%. For example, with a 20% discount, if new investors pay $1.00 per share, note holders convert at $0.80 per share.
• Valuation Cap: The maximum company valuation at which the note will convert. This protects early investors from being diluted if your company's value increases significantly before the next round. For founders, agreeing to a very low cap can mean giving up more equity than expected.
• Interest Rate: Interest accrues until conversion or maturity. Some notes are zero-interest, but most have a rate between 4% and 8%. Accrued interest often converts into equity along with the principal.
• Maturity Date: The deadline for conversion or repayment. If the note does not convert by this date, the investor may demand repayment or negotiate new terms. Some notes allow for automatic conversion at maturity at a set price, while others require cash repayment.
• Conversion Triggers: Most notes convert automatically at a qualified financing, but some allow conversion at the investor's option or upon a change of control (such as a sale of the company).
• Repayment Terms: If the note does not convert, what happens? Some notes require repayment of principal plus interest; others allow for conversion at maturity at a set price or on investor demand.
• Change of Control Provisions: What happens if your company is sold before the note converts? Some notes provide for automatic conversion, while others require repayment or a premium payout (such as 2x the principal amount).
• Most Favored Nation (MFN) Clauses: These give note holders the benefit of any better terms you offer to future investors, which can complicate later fundraising rounds.
• Prepayment Rights: Can you repay the note early, or does the investor have to agree? Some notes restrict early repayment to protect the investor's upside.

Example: If your note has a $2 million valuation cap and you later raise at a $10 million valuation, the note converts at the $2 million cap, giving the investor a much larger share of the company than new investors at the $10 million price. This can surprise founders who did not model the cap table impact in advance.

Common Mistakes Founders Make With Convertible Notes

Many founders make avoidable mistakes when negotiating or signing convertible notes. Here are some of the most common:

• Not Reading the Fine Print: Relying on a template or sample note without checking the details can lead to unfavorable terms, such as high interest rates, aggressive repayment triggers, or hidden MFN clauses.
• Ignoring the Cap Table Impact: Failing to model how the note will convert can result in unexpected dilution or loss of control after the next financing round. Always use a cap table tool or spreadsheet to test different scenarios.
• Overlooking State Law Differences: While federal securities laws set the baseline, state laws (often called blue sky laws) may impose additional requirements or restrictions on convertible note offerings. For example, California, New York, and Texas each have their own securities registration exemptions and notice filings. If you are raising from investors in multiple states, you may need to comply with several sets of rules.
• Assuming All Notes Are Standard: Investors may propose terms that are outside market norms, such as high discounts, low valuation caps, or unusual conversion triggers. Do not assume that all convertible notes are alike.
• Missing Tax Implications: Convertible notes can have tax consequences for both founders and investors, especially if the note accrues significant interest or if the company is sold before conversion. For example, accrued interest may be taxable to the investor even if it is not paid in cash.
• Not Planning for Maturity: If your company does not raise a qualified financing before the maturity date, you may be forced to repay the note or renegotiate under pressure. This can create cash flow issues or force founders to accept unfavorable terms.
• Failing to Disclose Risks: Not providing adequate disclosures to investors can create legal risk, especially if the company later faces financial trouble. The SEC and state regulators expect startups to provide truthful, complete information about risks and company status.

Example: A founder in Delaware raises funds from investors in California and Texas using a convertible note. The founder only checks federal SEC rules, but misses that California requires a notice filing and Texas has its own securities exemption process. This oversight could lead to regulatory penalties or a forced rescission offer to investors.

When Should You Speak With an Attorney?

Not every convertible note deal requires extensive negotiation, but there are key moments when legal advice is especially important. Consider speaking with an attorney if:

• You are raising your first round of outside capital and are unfamiliar with convertible notes.
• An investor proposes terms you do not fully understand, such as an unusually low valuation cap, high discount, or complex conversion triggers.
• Your note includes non-standard provisions, such as MFN clauses, change of control payouts, or mandatory repayment at maturity.
• You are raising funds from investors in multiple states, which may trigger additional securities law compliance requirements. For example, New York and Florida each have unique blue sky law requirements.
• You are unsure how the note will affect your cap table or future fundraising rounds. Modeling different conversion scenarios can be complex, especially if you have multiple notes with different terms.
• You want to ensure your disclosures to investors are adequate and meet federal and state requirements. The SEC expects startups to provide material information and not mislead investors.
• You need to coordinate with your company's bylaws, existing shareholder agreements, or prior financing documents. For example, some Delaware corporations have investor rights agreements that can restrict new securities offerings.

An attorney can help you review the terms, negotiate changes, and ensure your fundraising complies with both federal and state securities laws. They can also help you understand the practical impact of different terms on your company's future, such as how a low valuation cap could affect founder ownership or how MFN clauses could complicate later rounds.

Federal and State Law Caveats: The US Securities and Exchange Commission (SEC) sets the baseline for securities offerings, including convertible notes. Most early-stage offerings rely on exemptions from registration, such as Regulation D (Rule 506(b) or 506(c)). However, state-level rules can add additional filing or disclosure requirements, especially if you are raising from investors outside your home state. For example, the Delaware Division of Corporations may have specific filing requirements if your company is incorporated there, and California's Department of Financial Protection and Innovation requires notice filings for certain exempt offerings.

Practical Example: A founder in Illinois raises $250,000 on convertible notes from investors in Illinois, California, and New York. The founder's attorney helps file the necessary Form D with the SEC, prepares blue sky filings for California and New York, and ensures the note terms do not conflict with the company's existing shareholder agreement. This avoids regulatory issues and investor disputes later.

Checklist: What to Review Before Signing a Convertible Note

Before signing a convertible note, founders should work through a practical checklist to avoid surprises:

• Review All Key Terms: Double-check the discount rate, valuation cap, interest rate, maturity date, and conversion triggers. Compare them to market norms for your stage and industry.
• Model the Cap Table: Use a spreadsheet or cap table tool to see how the note will convert under different scenarios. Include multiple notes if you are raising from several investors.
• Check for Unusual Provisions: Look for MFN clauses, prepayment restrictions, or change of control payouts that could affect future deals. Ask your attorney to flag any terms that are outside the norm.
• Confirm Securities Law Compliance: Ensure your offering qualifies for a federal exemption (such as Regulation D) and check for any state-level requirements. Prepare and file any necessary notices or forms.
• Prepare Disclosures: Draft a clear summary of risks and company information for investors. Include details about the company's financials, business plan, and known risks.
• Coordinate With Existing Agreements: Make sure the note does not conflict with your company's bylaws, operating agreement, or prior investor agreements. For example, some agreements require board approval for new debt or equity issuances.
• Plan for Maturity: Have a backup plan in case you do not close a qualified financing before the maturity date. Consider negotiating for automatic conversion at maturity rather than mandatory repayment.
• Consult an Attorney: If you are unsure about any term or legal requirement, seek legal advice before signing. An attorney can help you negotiate better terms and avoid costly mistakes.

Example Checklist in Action: A founder preparing to sign a convertible note reviews the discount rate (20%), valuation cap ($4 million), and maturity date (18 months). She models the cap table to see how much equity the note will convert into if the next round is at $8 million. She notices an MFN clause in the draft note and asks her attorney to explain its impact. Her attorney also helps her file a Form D with the SEC and a blue sky notice in her home state. By following this checklist, she avoids unexpected dilution and regulatory problems.

FAQs

Are convertible notes considered securities under US law?

Yes, convertible notes are generally considered securities under US federal law. This means that offering convertible notes is subject to SEC rules and regulations, including the need to qualify for an exemption from registration. Most early-stage startups rely on exemptions such as Regulation D, but you should also check state-level requirements, which can vary and may require notice filings or other compliance steps.

What happens if my startup does not raise a qualified financing before the note matures?

If your company does not complete a qualified financing before the maturity date, the note may become due for repayment. Some notes allow for conversion at maturity at a set price, while others require cash repayment of principal and interest. If you cannot repay, you may need to negotiate an extension or new terms with your investors. Planning for this scenario in advance can help avoid a cash crunch or investor disputes.

Can I use a convertible note to raise funds from non-accredited investors?

It is possible, but it increases legal risk. Most convertible note offerings are limited to accredited investors to qualify for certain SEC exemptions. Raising from non-accredited investors may trigger additional disclosure and filing requirements and increase the risk of regulatory scrutiny. Some states have stricter rules for non-accredited investors, so always check both federal and state requirements before accepting investments from non-accredited individuals.

What is a valuation cap, and why does it project?

A valuation cap sets the maximum company valuation at which a convertible note will convert into equity. It protects early investors from being diluted if your company's value increases significantly before the next financing round. For founders, agreeing to a very low cap can lead to giving up more equity than expected, so it is important to model different scenarios and negotiate a cap that makes sense for your business stage.

How do state laws affect convertible note offerings?

State securities laws (blue sky laws) can require additional filings, disclosures, or exemptions for convertible note offerings. For example, California, New York, and Texas each have their own notice filing requirements for exempt offerings. If you are raising from investors in multiple states, you may need to comply with several sets of rules. Failing to do so can result in penalties or forced rescission offers to investors. Consulting an attorney with experience in multi-state offerings is highly recommended.

Key Takeaways

• Convertible notes are a flexible tool for early-stage fundraising, but the specific terms can have a major impact on your company's future.
• Key terms to review include discount rate, valuation cap, interest rate, maturity date, and conversion triggers. Always model the cap table impact before signing.
• Federal securities laws apply to convertible notes, and state laws may add additional requirements. Compliance with both is essential to avoid legal risk.
• Common mistakes include overlooking the cap table impact, ignoring state law, and failing to plan for maturity. Always review the fine print and seek legal advice if needed.
• Consult an attorney if you are unsure about any term, legal requirement, or the impact on your company's ownership. Legal review can help you negotiate better terms and avoid costly errors.

If you are considering raising funds with a convertible note or have questions about specific terms, our team can help you understand your options and risks. Contact us at (888) 449-8437 or team@sprintlaw.com to arrange a consultation. Where legal services are required, they are delivered by licensed lawyers at trusted US law firms through the Sprintlaw platform.