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Convertible notes are often used by angel investors who wish to fund businesses without establishing an explicit valuation of the company in which they are investing.
When an investor purchases equity in a startup, the purchase price of the equity implies a company valuation. For example, if an investor purchases a 10 per cent ownership stake in a company, and pay $1m for that stake, this implies that the company is worth $10m.
Some early stage investors may wish to avoid placing a value on the company in this way, because this in turn will affect the terms under which later-stage investors will invest in the company.
Convertible notes are structured as loans at the time the investment is made. The outstanding balance of the loan is automatically converted to equity when a later equity investor appears, under terms that are governed by the terms set by the later-stage equity investor. An equity investor is someone who purchases equity in a company.