With the current share market tech rout and growth in private credit, we are seeing cash-strapped start-ups turning to convertible notes as an alternative to a traditional equity round. On the surface, they seem like the perfect solution: get the funding you need now and worry about the company valuation later.
We are concerned that Directors don’t understand the true, and often astronomical, cost of these instruments.
What is a Convertible Note?
Simply put, a convertible note is a form of short-term debt that converts into equity at a later date, possibly during a future funding round. It allows companies to raise funds without having to put a firm valuation on their business today. An investor lends you money, and if you can’t pay them back in cash, they receive shares in your company at a future, based on a formula.
The Hidden Sting: Beyond the 12% Interest Rate
Directors might look at a convertible note with a 12% interest rate and think it’s a reasonable cost of capital. The danger, however, rarely lies in the stated interest rate. The real cost is buried in the fees and conversion terms.
We’ve recently seen complex notes with conversion mechanics or “free” attaching options linked to variable share prices or the growth in the share price itself. These terms are often so opaque that calculating the real economic cost is far from straightforward. What you’ve actually given away isn’t just debt; it’s a powerful financial derivative.
Under Australian and International Accounting Standards (AASB 9 & IFRS 9), these features must be recognised and accounted for. The note must be split into two parts:
- A Host Debt Liability: The simple loan component.
- An Embedded Derivative Liability: The “option” you’ve given the noteholder to convert their debt into valuable equity.
This embedded derivative must be measured at fair value on your balance sheet at each reporting date.
How We Uncover the Truth: The Monte Carlo Simulation
To calculate the fair value of these complex embedded derivatives, we can’t just use a simple online option calculator. We typically employ a Monte Carlo simulation.
In essence, we use a Geometric-Brownian Motion (GBM) process to simulate 100,000 different potential future paths for your company’s stock price. For each path, we calculate the likely payoff to the noteholder based on the complex legal clauses in the agreement. The tricky part is translating the convoluted “greater of” thresholds and variable conversion triggers from the often-opaque legal document into mathematical formulas for the payoff.
The fair value is the average of the present value of all 100,000 potential outcomes. Two key inputs drive this valuation: the current share price and our estimate of its volatility. For a high-growth start-up, volatility is often extremely high, which dramatically increases the value of the option you’ve given away.
A Real-World War Story: The $100 Million Liability
A recent example of a small ASX listed tech company surprised even us.
The company secured a much-needed $10 million cash injection via a convertible note. The funding was existential, it meant survival. On paper, the terms looked manageable.
However, the company then achieved a major technical milestone, and before their next valuation date on 31 December 2025, their implied share price had increased more than 16 times from inception!
What happened to the convertible note? The embedded derivative – that “option” to convert – was now deep in the money for the investor. When we ran our valuation:
- The fair value of the embedded derivative liability on the company’s balance sheet had exploded to over $100 million.
- The Effective Interest Rate (EIR) on the original $10 million loan was calculated to be more than 50%.
I doubt the company anticipated this outcome and they happily took the extraordinary share price growth. While the liability is “non-cash” (it will be settled in shares, not cash), it represents an unintended super-payoff and liability on the balance sheet. With the benefit of hindsight, the potential dilution is probably greater than it needed to be. But timing is everything.
The Takeaway for Directors
The difference between getting funding and failing is often binary. And sure, the investor is taking a lot of risk lending to a company with often no short-term ability to service traditional debt. But funding should not come at an unquantified cost.
Before you sign that convertible note term sheet, we urge Directors to look beyond the coupon rate. Ask yourself:
- Have we modelled the potential impact of these conversion terms under a best-case scenario for the company?
- Do we understand the potential effective interest rate, dilution and the liability this will create on our balance sheet?
Engaging a valuation specialist is not just a year-end compliance exercise for the auditors. Getting advice before you sign can save you from giving away a lottery ticket. That “simple” note might be the most expensive money you ever take.
