Convertible Notes Explained in 201 Words
a quick primer on the financial instrument used for startup investing.
Convertible notes are a financial instrument for early stage venture fundraising that provide benefits to both entrepreneurs and early investors. They move much faster than equity financing and give investors a premium for taking on early risk.
In San Francisco (URX is in South Park) coffee shops it’s common to hear:
“He invested $100,000 at a 20% discount with a $5M cap.”
Capped Notes (a form of “convertible debt”) convert to Common Shares in the Company at its next round of funding. For startups, this is usually a Series A round.
- Notes usually have a Discount that gives them investors a premium for being early and taking on more risk.
- They can also have a Cap to help protect investors against downsides if you grow too quickly. This helps fully align the incentives of the entrepreneur and the investor.
There are two main scenarios where Capped Note converts to equity:
- Scenario 1: The Series A round is at a valuation above $5M (for example, $10M). Investor gets 100,000/5,000,000 (2 %) ownership.
- Scenario 2: The Series A round is at a valuation below $5M (for example, $2M). Investor gets (100,000/(1-.2)) / 2,000,000 (6.25 %) ownership.
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