A senior convertible note is a debt security that contains an option in which the note will be converted into a predefined amount of the issuer's shares. A senior convertible note has priority over all other debt securities issued by the same organization.
Breaking Down Senior Convertible Note
A convertible note is a debt instrument often issued by angel or seed investors looking to fund an early stage startup which has not been valued explicitly. After more information becomes available to establish a reasonable value for the company, convertible note investors can convert the note into equity. The firm valuation will usually be determined during Series A financing round. So instead of a return in the form of principal plus interest, the investor would receive equity in the company. If the company fails after issuing a convertible note and defaults on its obligations, its note holders will probably be unable to get their initial seed or investment back. If there’s anything to be gotten, convertible note holders will fall in line after secured debt holders and before shareholders.
A type of convertible note is the senior convertible note. While the lender in a senior convertible note agreement has the option of converting his or her notes to shares of the borrowing company, the lender also has a senior claim on the borrower’s assets in the event of bankruptcy.
The senior convertible note holder receives two benefits not found on a normal bond issue – a call option and priority for recourse if the issuer goes bankrupt. Due to these added benefits, the amount of interest offered to the note holder will tend to be lower than on any other bond provided by the same issuer.
The worst-case scenario of holding a senior convertible note would be if the issuing company initially performed well, meaning that the debt would be converted into shares, and subsequently went bankrupt. The converted shares would become worthless, but the holder of the note would no longer have any recourse.