What is a Convertible Note?

A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. In effect, the investor loans money to a startup and instead of a return in the form of principal plus interest, they receive equity in the company. One advantage of issuing convertible notes is that it does not force the issuer and investors to assign a specific value to the company at a stage where insufficient information is available. The valuation will usually be determined during a qualified financing event (typically a follow-on round) when there are more data-points off which to base a valuation. In addition, convertible notes can be cheaper and quicker to an issue than preferred stock due to lesser legal costs.

Terms

When looking at a convertible note, there are a few key parameters that must be kept in mind:

  • Discount Rate: This represents the valuation discount you receive relative to investors in the subsequent financing round, which compensates you for the additional risk you bore by investing earlier.
  • Valuation Cap: This caps the price at which your notes will convert into equity and provides convertible note holders with an additional protection to the extent the company raises its next round at a valuation which exceeds the valuation cap.
  • Interest Rate: Since you are lending money to a company, convertible notes typically accrue interest as a form of additional compensation for the time in which your note is outstanding. However, as opposed to being paid back in cash, this interest typically accrues as additional principal (also known as paid-in-kind), increasing the number of shares issued upon conversion.
  • Maturity Date: This denotes the date on which the note is due, at which time the company needs to either raise a qualified financing or repay the note. This effectively limits the runway the company has to raise its next round and convert your note to preferred stock.­­­­­­

The concepts described above are subject to the actual documents of the convertible note and there are other terms that can be important depending on the specific wording of the legal documents.

Examples

Let’s walk through a few examples of what this conversion into equity may look like. We’ll start by singling out two of the most important variables associated with a convertible note – the valuation cap and discount rate – and then will see how these two interact. For simplicity’s sake, we will ignore accrued interest in our calculations.

Cap With No Discount

In our first example, we’ll imagine that a company raised its seed round by issuing a convertible note with a $4M valuation cap and no discount before raising its Series A round at a $12M pre-money valuation and a $10 price per share. In order to calculate the valuation cap adjusted price per share for convertible note holders, the valuation cap on the note should be divided by the pre-money valuation of the subsequent round and apply that to the Series A price per share. In this example that works out to $3.33 per Series A share for convertible note holders. Dividing a hypothetical $10,000 investment by that $3.33 per share price would grant the seed investor approximately 3,000 shares. Note that an investor investing that same $10,000 directly in the Series A round at $10 per share would only be issued 1,000 shares.

Discount With No Cap

Now let’s suppose a company raised its seed round by issuing a convertible note that had no valuation cap but did have a 20% discount to the Series A round. Again, let’s assume a $12M pre-money valuation and a $10 price per share. Applying the 20% discount to that price per share would yield a discounted price per share for the convertible note holder of $8. If an investor were to have invested $10,000 in the convertible note, they would, therefore, receive 1,250 Series A shares. Again, note that that same $10,000 invested by a Series A investor would be issued 1,000 Series A shares.

Cap and Discount Together

More often than not though, convertible notes have both a valuation cap and discount and will convert using whichever method gives the investor a lower price per share. Combining our previous examples, let’s say an issuer raises its seed round by issuing a convertible note with a $4M valuation cap and a 20% discount. Assuming the same future financing with a $12M pre-money valuation and a $10 price per share, the valuation cap would drive the conversion price given that it results in a lower price per share than the discount.

This post was written by anmareewilliams on August 30, 2016

Convertible Notes

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