Convertible Note: Interest Rate; Duration & Maturity Date

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Explanation of Interest Rate, Duration and Maturity Date as it applies to convertible notes used for financing your startup

(Convertible Note article continued)

Interest Rate:
What Interest rate will you offer?

Only the relatively low AFR (Applicable Federal Rate) is required by the IRS to avoid imputed interest. (In other words, if the interest rate is below this, the IRS will tax you as if the interest rate were higher, or, as if this were a gift.) However, typically a “high” rate is necessary to get investors, for example, 6%-10%, (and usually above the minimum AFR). You’ll need to adjust based on market conditions and other terms of the Note. You can make the determination if the interest is simple or compound.

Tip:  Leave yourself the flexibility to pay off the interest earned to minimize the dilutive impact on conversion of the note and/or have the interest not subject to the convertible discount, if offered.

Tip: Remember to collect a W9 for tax reporting on the interest earned.

Duration and Maturity Date:
How long is the Note for? 1 year?

What happens if the Note matures and an equity financing has not occurred? Does it automatically convert to common stock if a financing did not occur, or roll over into a term Note payable over time?

One option is to set a conversion at maturity date if no equity event took place, using a pre-determined valuation and terms. You might have the note convert to a term note at maturity.

Tip: In general, investors don’t want to call the note in. Rather, set the date with an understanding of how much time you need before you will can secure a Series A round of financing.

Tip: It is in your interest to push the maturity date out to give yourself enough time to attract a Series A investor.

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