What Is a Senior Convertible Note?
A senior convertible note is a debt security that contains an option in which the note will be converted into a predefined amount of the issuer's shares. A senior convertible note has priority over all other debt securities issued by the same organization.
Just like any other debt investment, senior convertible notes offer investors the ability to earn interest. Rather than cash payments, however, the interest payments typically will accrue and the amount the company owes the investor will increase over time
Key Takeaways
- A senior convertible note is a debt security that contains an option making the note convertible into a predefined amount of the issuer's shares.
- Both startup companies and established companies may choose to issue senior convertible notes as a means to raise funds from investors.
- Investors of senior convertible notes benefit from the option to convert their notes into shares of the issuing company and from a priority for recourse if the issuing company goes bankrupt.
- Since senior convertible notes have more benefits than convertible notes, they also pay a lower interest rate.
- Some investors purchase senior convertible notes with the goal of reaping significant profits if the startup has a successful initial public offering (IPO) or is acquired by another company.
How a Senior Convertible Note Works
A senior convertible note is a type of convertible note. A convertible note is a debt instrument often used by angel or seed investors looking to fund an early-stage startup that has not been valued explicitly. After more information becomes available to establish a reasonable value for the company, convertible note investors can convert the note into equity. Investors have the option to exchange their notes for a predetermined number of shares in the issuing company.
The firm valuation will usually be determined during the Series A financing round. So instead of a return in the form of principal plus interest, the investor would receive equity in the company.
Both startup companies and well-established companies may opt to issue senior convertible notes to raise funds from investors. This type of company financing has the advantage of being fairly simple to execute. This means the process of issuing the notes is relatively inexpensive, allowing for quicker access to investor funding than issuing equity.
Convertible Notes vs. Senior Convertible Notes
Senior convertible notes take priority over other debt that the company may have issued, as well as over equity holders. This means that, if the company fails, the owners of senior convertible notes are more likely to recoup their losses.
Senior Convertible Notes and Company Default
If the company fails after issuing a convertible note and defaults on its obligations, its noteholders will probably be unable to get their initial seed money or investment back. If there’s anything to be gotten, convertible noteholders will fall in line after secured debt holders and before shareholders.
While the lender in a senior convertible note agreement has the option of converting their notes to shares of the borrowing company, the lender also has a senior claim on the borrower’s assets in the event of bankruptcy.
Senior convertible notes have a maturity date, which is the date the notes are payable to investors if they have not already been converted to equity.
Advantages and Disadvantages of Senior Convertible Notes
Advantages
The senior convertible noteholder receives two benefits not found on a normal bond issue—a call option and priority for recourse if the issuer goes bankrupt. Due to these added benefits, the amount of interest offered to the noteholder will tend to be lower than on any other bond provided by the same issuer.
From an investor's perspective, senior convertible notes can represent an opportunity to invest in the early stages of a startup with the potential to reap profits if there is a successful initial public offering (IPO) or acquisition. Investors who purchase senior convertible notes from an established company often are looking for an investment with a limited downside risk even if it comes at the expense of limiting upside potential as well.
Disadvantages
On the downside, convertible notes have the potential to be dilutive and dilute earnings per share (EPS) when they are converted into shares. Moreover, conversion by large note holders can lead to a shift in voting rights and control of the company to those new shareholders.
The other major downsides include many of those associated with issuing debt in general, such as the risk of default and harm to the issuer's creditworthiness. This type of financing is popular among start-up companies, and a downside to this quick access to investor funding is that new companies may end up carrying excessive debt, which could push them into insolvency or bankruptcy.
For investors, senior notes pay lower rates of interest than junior bonds because they carry a lower degree of risk since senior notes are the first to be repaid in the case of a default.
Pros and Cons of Senior Convertible Notes
Pros
Investors enjoy the guarantees of debt but the option to convert to shares
Often a cheaper and easier option for companies to raise financing
Senior notes have higher priority than junior notes
Cons
Conversion can be dilutive
Conversion can lead to changes in equity control and voting
Pays lower interest than more junior debt
Convertible Note Terms
The specific terms of a convertible note will depend on the negotiations between the company and the investor. Below are some of the most common terms found as part of a convertible note.
Conversion Price
The conversion price is the price at which the convertible note can be converted into equity. It is usually set at a discount to the price at which the company issues equity in a subsequent financing round.
Conversion Ratio
The conversion ratio is the number of shares of equity that the convertible note can be converted into. It is calculated by dividing the principal amount of the note by the conversion price.
Maturity Date
The maturity date is the date on which the convertible note must be repaid, either in cash or through conversion into equity. The convertible note ceases to exist beyond the maturity date, though both parties may agree that the note may be rolled into a new security.
Interest Rate
Convertible notes may or may not pay interest to investors. If they do, the interest rate is typically lower than that of other types of debt instruments, such as bonds. The rate is usually lower because in exchange for sacrificing some profit, the investor receives greater flexibility in the capabilities of the investment.
Conversion Triggers
Conversion triggers are events that must occur before the convertible note can be converted into equity. Common triggers include the closing of a subsequent financing round or an IPO of the company's stock. If these events do not happen, the note can not be converted.
Valuation Cap
The valuation cap is the maximum valuation that is placed on the company at the time of conversion. If the company is valued higher than the cap at the time of conversion, the investor may convert the note at a lower conversion price to compensate for the higher valuation.
Security Interest
A security interest is a reference to some assets of the company pledged against the note. A security interest gives investors additional protection in the event of default. If the company defaults, the investor may take partial or full ownership of the secured asset in exchange for loss on their debt holding.
Special Considerations
One concern with early-stage companies is the possibility they will not be able to continue to raise additional rounds of equity financing after issuing a senior convertible note. Because of this, these companies may not have the money to pay back noteholders at maturity if the notes fail to convert. Some investors may require contingency stipulations to offer some protection before investing in early-stage companies that are perceived to be a higher risk.
The worst-case scenario of holding a senior convertible note would be if the issuing company initially performed well, meaning that the debt would be converted into shares, and subsequently went bankrupt. The converted shares would become worthless, but the holder of the note would no longer have any recourse.
Why Do Companies Offer Senior Convertible Notes?
Convertible notes and senior convertible notes are a popular way for companies to borrow money with lower interest obligations than other kinds of debt. When note-holders redeem their notes for company shares, they reduce the company's debt obligations. They are also less complex than other offerings, another advantage for startup companies.
Why Would an Investor Buy Senior Convertible Notes?
The owner of a senior convertible note has the option of converting the debt into equity in the company. If the company goes bankrupt, senior noteholders take priority in repayment over the holders of other kinds of debt. Alternatively, if the company does well, the notes can be converted into valuable shares.
Because of these features, investors often prefer this type of security.
What Is a Convertible Promissory Note?
A convertible promissory note is a promissory note that can be converted into equity, like other convertible debt. Typically, the conditions for conversion are automatic, requiring no further action from the note holder.
What Is a Senior Notes Offering?
A senior notes offering refers to the sale of senior notes by a company seeking to raise money from investors. Typically, the announcement of a senior notes offering is accompanied by a legal disclosure of the amount the company is seeking to raise, and what the company plans to do with the money.
The Bottom Line
Senior convertible notes are popular funding options that have the features and protections of debt, but can also be converted into equity shares at a later date. Holders of senior convertible notes may choose to hold them until bond maturity or to convert the notes into a specified number of common stock shares if the company's value grows. Conversion, however, can often be dilutive. Because they are senior, they have priority for repayment in the event of default or bankruptcy, and so carry less risk than more junior notes.
