How Convertible Notes Work

If you’re an entrepreneur, here’s what you need to know about seed stage funding.

Quake Capital
Jul 24, 2018 · 5 min read

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.

Convertible Notes

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.

Pricing Discount

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).

Valuation Cap

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.

KISS Document

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Written by Anjali Agarwal, Junior Associate at Quake Capital

Quake Capital

Quake is a unique accelerator focused on making seed…

Quake Capital

Quake is a unique accelerator focused on making seed investments in early stage ventures across a wide range of industries. With offices in New York City, Los Angeles, and Austin, Quake has the ability and network to help companies be successful. Visit us at quakecapital.com.

Quake Capital

Written by

Quake is a unique accelerator focused on making seed investments in early stage ventures across a wide range of industries. Visit us at quakecapital.com/blog

Quake Capital

Quake is a unique accelerator focused on making seed investments in early stage ventures across a wide range of industries. With offices in New York City, Los Angeles, and Austin, Quake has the ability and network to help companies be successful. Visit us at quakecapital.com.