A convertible note is a fundraising tool that young companies can use to raise money.
In essence, a convertible note is a loan document that can be converted into equity at a specified value, when the re-payment comes due. There are several advantages to a convertible note rather than a straight equity investment:
- If a business is surviving but not exceeding expectations, the investor can get their money back at a set interest rate at the end of the term.
- If a business is meeting or exceeding expectations and the value of a future exit might exceed that of the original loan plus interest, the holder of the note can convert the note into equity in lieu of repayment.
A convertible note is also a way to assign a value to a company without issuing actual stock, something that most young companies can't afford at an early stage. Convertible notes are commonly issued in a friends & family or Series A early stage start up round.
On Shark Tank, when a shark asks what value a note has been given, this refers to the hypothetical value of the company at the time the note is converted. For instance, a note my specify that the value of the company at conversion time is $8,000,000 which is the value at which the note is converted even if another fundraising round had taken place and the value at which that round was raised was higher, thus providing a discount to the investors.
A convertible note may only be issued to an accredited investor as defined by SEC regulations.