The Basics of Convertible Notes
There are many ways to raise financing for your company, but one of the most popular is a convertible note.
With a convertible note, the investor loans money to the startup in return for equity in the company (rather than a payout of the principal plus interest).
In this article, we’re going to cover the three most common terms you’ll come across in a convertible note: interest rate, conversion discount, and valuation cap.
- What is a Convertible Note?
- What’s the Benefit of a Convertible Note?
- Terms of Convertible Notes
- Term 1: Interest Rate
- Term 2: Conversion Discount
- Term 3: Valuation Cap
- How Do Convertible Notes Affect Dilution?
- How to Be Smart with Convertible Notes
Before we can completely understand the terms in a convertible note, we need to understand what a convertible note is and how it differs from a convertible security.
What is a Convertible Note?
A convertible note is a type of convertible security. So then what’s a convertible security? Convertible securities include various instruments that expect to ultimately become stocks such as SAFE’s KISS-A’s and convertible notes. Within the world of convertible securities, convertible notes take up a space that is known as debt equity.
Essentially, convertible notes act as an IOU, but instead of paying cash, you pay in equity. Here’s a more formal definition…
Convertible notes also carry a unique characteristic among investments. Typically, investors can only cash out during a liquidity event, like the sale of the company, but convertible notes are technically debt, and as such, if held to maturity, a note holder could demand payback.
The maturity date is a deadline for a preferred round, and only during a preferred round can a convertible note convert into equity. Let’s say there was a maturity date of 2 years from the date of investment. If the company hasn’t had a preferred round within 2 years, the investor could demand their money back. It’s not commonly done, but it’s good to know that the term exists.
We wrote a comprehensive blog on convertible debt.
What’s the Benefit of a Convertible Note?
It’s important to know when and why companies would issue convertible notes.
Say someone asked you to be an investor in their company, but all they had was an awesome idea. It’d be pretty hard for them to issue you stock since there’s no real way to give that stock a value.
So, if all you have is an idea, there’s not much to go on to value that stock. This is how convertible notes were born. They allow investors to bring money to the table early on in a startup and convert that debt into equity at a later time, with special terms that make their earlier investment worthwhile.
The benefit is that entrepreneurs and startups can get funding without having to define the value upfront and investors can take an early stake in the company.
We’ll cover more about the history of convertible notes and why and when to use them in part II of this series.
Terms of Convertible Notes
There are three main unique features of convertible notes, besides the maturity date we mentioned above.
We’re going to cover each convertible note feature separately, but one thing to keep in mind is that these aren’t required. They are negotiable levers, and the more you know about these terms, the more prepared you’ll be for that negotiation.
It’s also good to know that convertible notes will regularly carry both valuation caps and discount conversions; however, only one term will be carried over during conversion. Whichever term ends up being more valuable to the investor at the time of conversion is the term that will be upheld.
So, if it is more beneficial for the investor to take the valuation cap rather than the conversion discount, that is the term that will apply when it’s time to convert the debt to equity and vice versa.
Be aware, all these terms will cause dilution but how much dilution occurs depends on how extreme the terms are. We’re going to talk about dilution a few sections down.
In part III of this series, we will break down how to calculate convertible debt into equity on your cap table.
Term 1: Interest Rate
This is exactly what it sounds like. We’re all familiar with interest rates. It’s how most lenders make a profit. Convertible notes are a debt instrument and are legally required to carry interest.
However, most of the time, the interest will be set to zero or the lowest interest rate legally required. Convertible notes can carry higher interest rates, but it’s not the rule.
Interest rates have two accrual methods, simple or compounding, and they usually carry a time frame for when and how the interest rate is calculated. Think of the monthly interest that accrues on your car loan or mortgage.
These terms are all negotiable, but interest is pretty standard. Don’t accept a crazy interest rate, but also be prepared to take convertible note investments for what they are — debt. And debt is required to pay interest.
Term 2: Conversion Discount
A conversion discount negotiates a lower share price when you convert your note to stock. When you have a convertible note, that debt will convert to equity in the next preferred round of financing, a series seed, A, B, C, etc.
The phrase, more bang for your buck, could sum up what a conversion discount does and why an investor would want this term included. You’re buying more with less.
Here’s an example: In the next round, the company raises money at $1.00 per share, and you had previously invested $100,000 on a convertible note with a 20% conversion discount. You would receive stock at $0.80/share, instead of $1.00. That would mean receiving 125,000 shares of stock, rather than the 100,000 shares your $100,000 would buy if you had waited to participate in the round directly.
The more shares you have, the more you’ll cash in on later as those shares appreciate in value.
Term 3: Valuation Cap
Ok, now for the trickiest of the terms. Valuation caps, also known as conversion caps, place a limit on the value of the company so that the note converts at no more than the agreed-upon cap.
A valuation cap sets a threshold for the convertible note so that the investor ends up owning a larger stake of the company. For example, if they made a million dollar investment and the company is later valued for 100 million dollars, they would only own ~1 percent of the company. That’s not much considering that without their initial million dollars there might not even be a company.
But, if they have a valuation cap of 10 million on their convertible note, they would own closer to 10 percent, which is a much more considerable stake.
A valuation cap is the sort of thing that’s hard to say in words but easy to express in a picture. So I made this. Please don’t laugh.
In the whiteboard example seen above, we walk through the math of a convertible note with a high valuation cap. The note is worth $1 million and the conversion cap is set at $7 million.
That means that the pre-money (prior to investment) equals $7 million and when you add the investment of $1 million, the post-money (after investment) equals $8 million.
Now, divide the value of the note by the post-money or $1 million over $8 million. That means the investor now holds 12.5 percent ownership in the company.
We’ll show you what a low valuation cap looks like in the next section.
How Do Convertible Notes Affect Dilution?
Any time a company takes on new money, they give out equity which dilutes the current shareholders.
Convertible notes are no different. They are investments that convert at a later time into equity, and depending on the severity of the terms set in the note, the amount of dilution will be subsequently affected.
This is when you need to be careful and make sure you understand the terms completely; otherwise, you could put your company and shareholders at risk.
I have a few more drawings to explain how each of the terms we listed impacts dilution.
Interest rates and conversion discounts are intuitive. The higher the amount, the greater the dilution.
Valuation caps are sneaky though. They go against how we intuitively think about dilution.
When a valuation cap is low, the dilution will be higher.
Here’s why: The math in this image is the same as in the high valuation cap example we shared earlier. What’s important to note is that a lower cap amounts to a lower rate of division and thus a higher percentage ownership. In this example, a $4 million dollar cap on a $1 million dollar investment leads to 20 percent ownership. That’s some serious dilution.
How to Be Smart with Convertible Notes
Convertible notes can be very friendly to early-stage companies and founders, but heed our words of warning – know the terms. If used correctly, convertible notes will be beneficial for founders and investors, but if used poorly, they can be costly for founders.
So how can you make smart choices with your equity? It comes down to resources.
Our blog is a resource that helps teach you about equity management at large and houses dozens of articles on topics from term sheets to stock option expensing. Knowledge is power, and being smart starts with a little homework.
Another resource at your disposal is Shareworks Startup Edition. We have automated scenario modeling tools that can model thousands of outcomes in a matter of minutes. These tools act as a convertible note calculator, making it possible to compare investor terms and dilution before and after a new preferred financing round.
If you use scenario modeling before accepting an investment, like convertible debt, you will be able to see exactly what that convertible debt will do to your bottom line, number of shares, dilution of current shareholders, etc.
Here is a helpful article that reviews how you can use startup edition's scenario modeling capabilities to model financing rounds and convertible notes.
It’s a powerful tool that keeps you confidently in control of your equity and enables you to make the best choices for your company and shareholders. To learn more, contact our team to set up a private demonstration of our solution and its scenario modeling tools.
