A Convertible Note (also known as a Convertible Loan Agreement) is an investment agreement between an early stage company and an investor. A Convertible Note allows the company to receive capital while not distributing shares to investors until a future date. The investment amount is a loan from the investor to the company. Investors are considered lenders until the loan amount is converted into equity or the investment amount is repaid. Once the loan converts to equity, investors will become shareholders.

Below we have explained some of the key terms used in a Convertible Note.
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A valuation cap is the maximum value of the company that will be used to calculate the conversion of the investment into shares. If the company's valuation meets or exceeds the cap in a future financing round, the Convertible Note will convert into shares at the valuation cap. If the company's valuation is below the valuation cap, the Convertible Note will convert at this lower amount.

Here are some examples of how a valuation cap works for early-stage investments. 

Example A: Conversion Above the Valuation Cap

In 2016, Blue Jeans Inc. raises $100,000 pursuant to a Convertible Note with Investor X.
The Note has a valuation cap of $1,000,000.  
Two years later, Blue Jeans Inc. agrees to raise $250,000 in funding from Venture Capital Group at a total company valuation of $5,000,000.

Pursuant to these terms: Investor X converts the Convertible Note at the valuation cap of $1,000,000. So Investor X receives 10% of the company's shares. 

Venture Capital Group will receive 5% of the company's shares for $250,000, as it has agreed to a higher valuation of $5,000,000.

Since Blue Jeans Inc. raised its second round above the valuation cap, Investor X benefits from their early investment by converting at a lower company valuation. 

Example B: Conversion Below the Valuation Cap

In 2016, Blue Jeans Inc. raises $100,000 pursuant to a Convertible Note with Investor X.
The Note has a valuation cap of $1,000,000.  
Two years later, in 2018, Blue Jeans Inc. agrees to raise $250,000 in funding from Venture Capital Group at a total company valuation of $750,000.

Pursuant to these terms: Investor X converts the Note at $750,000 because the company has not raised money at or above the valuation cap. So Investor X receives 13.3% of the company's shares ($100,000 / $750,000).

Venture Capital Group will receive 33.3% of the company's shares for $250,000, as it has agreed to a valuation of $750,000.

Since Blue Jeans Inc. raised its second round of financing below the valuation cap, Investor X receives a higher portion of shares. However, Investor X won't be happy with this outcome, as the overall value of the company is less than the valuation cap.

A discount is a reduction in price the investor will receive when converting their investment into shares. Instead of setting a maximum value of the company through a Valuation Cap, a Discount gives a specific price advantage to early-stage investors. 

Example - Convertible Note with Discount

In 2016, Blue Jeans Inc. raises $100,000 pursuant to a Convertible Note with Investor X.
The Note has a valuation cap of $1,000,000 discount of 20%.
Two years later,  Blue Jeans Inc. agrees to raise $250,000 in funding from Venture Capital Group at a total company valuation of $5,000,000 for which it will receive 5% of the company's shares.

Due to the valuation cap (as described in Example A in the section above), Investor X converts the Convertible Note at the valuation cap of $1,000,000. So Investor X would normally receive 10% of the company's shares. However, in this instance Investor X is also entitled to a 20% discount.  Therefore Investor X converts the Note as if $120,000 (the investment amount plus 20%) had been invested in the Note on a company valuation of $1,000,000. So Investor X receives 12% of the company's shares. 

If your company raises money from investors after the Convertible Note is signed, it might not be the right time to convert the Note into shares for the investor. Typically, investors only want the Convertible Note to convert into shares after the company has participated in a significant financing round. The amount of funding used to define "significant" will depend on the company, the investor, and everyone's funding expectations. If the significant financing amount is too high, the investor might have to wait longer to convert. However, if the significant financing amount is too low, the conversion might take place when the company is still at a very early stage.

Investors sometimes request the ability to convert the Convertible Note into shares at any time, regardless of additional funding obtained by the company. This term gives significant discretionary power to the investor, but it can cause uncertainty for the company as it may have to arrange for the share conversion at an unexpected time.

The maturity date is when the agreement between the investor and the company expires and the money loaned by the investor plus interest becomes due. The goal under a Convertible Note is to ensure the investor's money is converted into shares before the maturity date. But the maturity date provides some assurance to the investor that the principal amount plus interest will be paid back in the future, even if no conversion has occurred.