I'm learning as much as possible about the funding mechanism of convertible notes. I understand that they are a loan until they convert to equity in the future once a more reasonable valuation is established. I realize they aren't given out to just everyone, and that companies who earn a convertible note are ones the investor believes will succeed based on team, product, etc. But some will still fail before their first round of funding. What happens to the convertible note?
Convertible notes are by no means "earned." They are often easier to raise for early-stage companies who don't want to or can't raise an equity round. Equity rounds almost always require a simultaneous close of either the whole round or a defined "first close" representing a significant share of the raised amount. Where there are many participants in the round comprised mostly of small seed funds and/or angel investors, shepherding everyone to a closing date can be very difficult.
If a company raises money on a note and the company fails, the investors are creditors, getting money back prior to any shareholder and any creditor that doesn't have security or statutory preference. In almost every case, convertible note holders in these situations would be lucky to get pennies back on the dollar. It would be highly unusual of / unheard of for a convertible note to come with personal guarantees.
Happy to talk to you about the particulars of your situation and explain more to you based on what you're wanting to know.
It depends on how the note is written. If it is not guaranteed by any of the principles, it is treated just like any other debt. If the company has funds it pays it's liabilities, if there is any cash left it goes to the equity holders.
If it has been personally guaranteed, then whoever provided the guarantee is personally responsible to pay it regardless of what happens with the company.
The practical answer is that if the company fails, the note holders will get nothing. Holding a note can be good if the company has a small exit in the future. Note holders will get first dibs on that exit cash. And in a big win, the ability to convert into shares means the note holder can still participate in those high-multiple returns.
Convertible notes can be a quick efficient way to get first investor dollars in. In most cases if the company doesn't make it to the next round or milestone, the company simply dissolves and everyone moves on to next. But be careful... If the noteholders continue to like parts of the IP, vision, or everything but you... in default they effectively own the company with no obligations to you and absent making the note whole have a pretty straight line there.