How Convertible Notes Work
If you’re an entrepreneur, here’s what you need to know about seed stage funding.
As an early stage VC, we invest in our portfolio companies through a common investment tool called the convertible note — specifically, we use the KISS Document here at Quake, a variation of a convertible note with friendlier terms. Many entrepreneurs and investors have discussed the merits of convertible notes at length, agreeing that the lack of extensive legal fees and speed with which convertible notes can be processed is a major upside. Ultimately, this investment tool was developed to allow seed stage founders, who are otherwise too small to obtain standard bank loans or larger checks from VCs that invest starting at Series A and beyond, to receive the funding they need to accelerate their growth and achieve the highly-coveted “hockey-stick” growth trajectory.
At the seed stage, there is insufficient information to truly determine an accurate valuation for a startup. Most startups’ revenues and assets aren’t going to be large enough for VCs to come up with a valuation that they and the founders can mutually agree upon — this is where convertible notes come into play. As the name suggests, a convertible note is a type of short-term debt that converts to equity after a conversion event occurs (usually when the startup raises a certain amount in its next fundraising round). Ultimately, the purpose of a convertible note is to defer valuing the startup until it has matured and proven itself further, thereby allowing the startup to generate more data points and reach certain metrics that will allow investors to arrive at an appropriate valuation in the future.
A seed round that utilizes convertible notes is also called an unpriced round, as VCs or angels don’t know the exact number of shares they’ll end up receiving in the future. Instead, they’re providing the startup with capital in the form of debt today, with the agreement that this investment will convert to shares after the conversion event.
After a startup raises convertible debt, the next moment its investors are anticipating is the startup’s subsequent financing round, also called the next equity financing. If this round is priced, meaning that shares and equity are up for grabs, the round serves as the conversion event that allows the seed investors’ convertible notes to convert to equity. The amount of equity a seed investor owns at this point can be calculated as the purchase price (the initial amount of capital the investor provided), divided by the conversion price, or the investor’s price during the equity financing round, which depends on two factors: the pricing discount and valuation cap.
The first major aspect of a convertible note is the pricing discount, which takes into account the high level of risk involved in investing at the seed stage and incentivizes investors to take a chance on startups that haven’t yet reached a stable level of growth. Through this pricing discount, which generally varies between 10 and 30 percent, seed investors are allowed to purchase shares at a lower price than investors that come on board later.
For example, let’s assume a startup raises $300,000 in convertible debt from several VCs at a 20% discount, and then goes on to raise a Series A round several months later. During the Series A round, new investors are offered shares at $1.00/share, but your original seed investors would receive their shares at a 20% discount, or $0.80/share. So, the original investors’ convertible notes will convert to 375,000 shares ($300,000/$0.80), while new Series A investors will get 300,000 shares for a similar investment, since they don’t receive the discount ($300,000/$1.00).
The valuation cap is another key component of a convertible note, which allows investors to convert their investment into equity at a predetermined valuation. In effect, this valuation cap can be thought of as the typical valuation that investors and founders agree upon during a priced round.
For example, let’s assume a startup raises $600,000 from several VCs at a $6M valuation cap, and several months later, it raises a $12M Series A round. The seed investors, because of the valuation cap, will see their investment convert to shares at a price of $6M, not $12M, which gives them a price half of onboarding Series A investors. The seed investors’ price will be $0.50/share, or $6,000,000 (valuation cap) divided by $12,000,000 (Series A total). New investors, however, only have the option of buying new shares at the offering price of $1.00/share. In this case, seed investors will receive 1,200,000 shares ($600,000/$0.50), while new investors will receive 600,000 shares ($600,000/$1.00) for the same investment.
The pricing discount and valuation cap ultimately work in tandem to determine a seed investor’s valuation, or conversion price, during the next equity financing. Let’s assume that a startup’s founders and VCs decide on a deal with a 20% pricing discount and an $8M valuation cap during a seed round, and the startup goes on to raise a Series A round a few months later. Any valuation during this round up to $10M will result in the 20% pricing discount being applied. If the Series A valuation, with the 20% discount applied to it, exceeds the valuation cap, then the pricing discount no longer applies — instead, the valuation cap is used in determining the investor’s valuation. So, in the case of a $15M Series A valuation, seed investors will receive shares at an $8M valuation (the valuation cap). On the other hand, a $9M Series A valuation will result in a 20% pricing discount to arrive at a $7.2M valuation for seed investors.
At Quake, we use 500 Startups’ KISS document, a proven tool that has successfully facilitated tens of thousands of seed deals and addresses common legal issues that entrepreneurs and investors have faced in the past. It differs from traditional convertible notes in that it isn’t a debt instrument and thus doesn’t accrue interest. Ultimately, however, the KISS serves the same purpose as a convertible note: to streamline the fundraising process for seed stage founders and enable them to take their venture to the next level, resulting in an exciting opportunity for VCs and founders alike.
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Written by Anjali Agarwal, Junior Associate at Quake Capital