Convertible Note Interest: What is the Range?

convertible note interest

While most startups and investors focus on convertible note terms like the discount and price cap, one important but overlooked term is convertible note interest. Since a convertible note is in fact a debt interest, it follows that the convertible note investment should accrue interest. However, startups should be mindful that but the rate of convertible note interest should actually be lower than a typical non-convertible loan from an investor.

The Range of Convertible Note Interest Varies

The range of convertible note interest is usually 2% to 8%, and most often 5% or 6%. Geography tends to play a role in the range of convertible note interest:  lower rates of interest are seen on the coasts and internationally, higher rates in the middle of the country.

When Convertible Note Interest Becomes a Factor

If a potential investor plays hardball and insists on a high interest rate (i.e., 9% or more), then you might have the wrong potential investor. Or at a minimum, a startup should view this as a yellow flag and your startup should pay attention to the other economic terms like price cap and the discount more closely. Although, if your startup is raising a small convertible note round (sub $100k), a couple extra interest points may not be that material.  But if your convertible note round goes towards the $1 million dollar range or above, interest becomes a material term in the aggregate.

What happens to Convertible Note Interest? Does it get paid out?

The convertible note interest should also accrue until the note converts into equity or is paid out at the sale of the company. When the convertible note converts into equity, the interest also typically converts into the preferred stock, rather than being paid out.  In fact, I don’t think we’ve ever seen a deal where the convertible note interest gets paid on a schedule or upon a preferred stock conversion (and we’ve done 100s of convertible note deals for both startups and investors).

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Conclusion

Frankly, if your potential investor wants a very high rate of convertible note interest and/or quarterly payment for the convertible note interest then he or she should invest in blue chip dividend stocks or bonds. The purpose of interest in a convertible note is to technically qualify the note as a debt instrument, and less about appreciating the time value of money — and definitely not about paying the investor interest with his or her investment money. If an investor gets too cute with trying to jack up the interest rate, I would attempt to push for a lower discount or price cap.  You never know…it might work.

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3 thoughts on “Convertible Note Interest: What is the Range?

  1. If the interest accrues annually and the corporation takes the interest deduction on the P&L does the corporation issue a 1099-INT to the non-corporate creditors?

  2. Convertible note templates may also define an expiration date of the loan, typically two years or so. If no qualified financing is received prior to the expiration date, and no other valuation event occurs before the expiration date, the loan is payable back to the investor with the accrued interest when the loan expires. There might also be a clause defining which party has the right to reject the payout at the expiration date, the investor, the entrepreneur or both.

    If only the investor is defined as the party who can refuse to accept the payout at the expiration date but he does not wish to exercise this right to refuse and he demands the payout at the expiration date, but the entrepreneur refuses to comply with the payout request insisting to wait for one or several qualified financing events way beyond the expiration date, does this constitute a breach of contract by the entrepreneur?

  3. How do I determine the value of a newly awarded patent in the energy field?

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