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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 would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor would receive equity in the company.

The primary advantage of issuing convertible notes is that it does not force the issuer and investors to determine the value of the company when there really might not be much to base a valuation on – in some cases the company may just be an idea. That valuation will usually be determined during the Series A financing, when there are more data points off which to base a valuation.

Convertible Note Terms

When evaluating 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

The valuation cap is an additional reward for bearing risk earlier on. It effectively caps the price at which your notes with will convert into equity and – in a way – provides convertible note holders with equity-like upside if the company takes off out of the gate.

Interest rate

Since you are lending money to a company, convertible notes will more often than not accrue interest as well. However, as opposed to being paid back in cash, this interest accrues to the principal invested, 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 repay it.


 

Convertible Note Examples

Let’s walk through a few examples of what this conversion into equity actually looks like. We’ll start by singling out the two 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.

  1. 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, you would divide the valuation cap on the note 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.
  2. 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. In this exercise, the pre-money valuation at which the Series A round was raised is not important, only the price per share. Again, let’s assume that it is $10. 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 only purchase 1,000 Series A shares.

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:

  1. 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. In our first scenario – where the company is raising at a $12M pre-money valuation and a $10 price per share – the 20% discount would convert seed investors at $8 per share. The valuation cap, however, would result in a $3.33 per share price and would be the price at which a note holder’s investment would convert into Series A shares.
  2. In our second scenario, the company is raising its subsequent round at only a $4.5M pre-money valuation and the same $10 per share price. The 20% discount would again result in an $8 per share price for note holders. Because dividing the $4M valuation cap by the $4.5M pre-money valuation and applying that to the $10 share price results in a higher $8.89 per share price for seed round investors, in this case it would be the discount that drives the conversion.

This article is a sample from our forthcoming SeedInvest Academy which will cover key topics in angel investing, venture capital and startup finance. We’ll also be previewing more articles here on the blog.

Note: This post is not a substitute for professional legal advice nor is it a solicitation to offer legal advice.  The foregoing is just a summary of typical terms – legal documents and terms vary widely and the foregoing may not be representative of the terms of any particular convertible note document.  Seek the advice of a licensed attorney in the appropriate jurisdiction before taking any action that may affect your rights.