Understanding The Convertible Note
A convertible note is a widely used debt instrument for seed investors. It is structured as a loan with the intent to convert to equity in a later round of funding. There are many advantages for early-stage startups to use convertible notes as opposed to raising priced equity rounds. The language is typically straightforward, the process is quick and investors won’t be given the right to buy the stock until the equity round. You also won’t have to stress about the valuation of your startup as it’s usually determined in the Series A round.
Although issuing convertible notes is now common practice, there is still a good deal of risk for both parties involved and you should be aware of parameters. The key terms include:
Valuation Cap
The valuation cap represents a startup's maximum valuation at which the early investors can convert their notes into equity. Caps add a layer of protection and incentive for the early investor to convert their note at a lower price than the Series A investors. If the subsequent financing round’s valuation is $4M and the cap is $1M, then the early investor receives their equity at one.
Discount
The discount rate is the discount on the Series A valuation at which the convertible note is converted to equity. The discount sets a percentage reduction and primarily exists to reward early investors because they assume more risk than later investors. The typical discount is 20%. For instance, if there is a 20% discount in the convertible note agreement and the Series A fundraise is $10M, then the early investor gets his equity at $8M.
Interest Rate
Remember, the convertible note is a loan and the startup, in some cases, is expected to pay interest. The startup's interest accrues on the outstanding principal amount. Interest is due and payable on the maturity date and will be calculated on the basis of a 365-day year for the actual number of days elapsed. The average interest rate is between 7%-10% annually. Highly active early-stage investors would rather place more emphasis on the other key terms in order to not be perceived as a loan shark.
Maturity Date
As stated above, the maturity date is the day the startup is expected to pay back the early investors. Maturity dates have to be renegotiated upon expiration. Extending maturity dates can be a pain especially because legal fees will incrementally add up.
Below is an example of when the valuation cap and discount rate are applied in a Series A conversion event:
- Valuation cap of $5M
- Discount of 20%
- Series A fundraise at $6M (pre-money valuation)
- Early investors will convert to equity at a $4.8M Valuation (20% of $6M)
Raising convertible notes is a quicker way to fundraise while not having to negotiate too many details. However, conversions can be complicated. Taxes, interest rates, and fixed terms represent different things across varying states. You also might not want to offer a valuation cap or your investor might request warrant coverage instead of discount rate. It’s important for founders to be well versed in venture financing and other available alternatives.
