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).
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.