Dear readers.

Today, I wanted to write a little about convertible notes, a type of financial instrument that are frequently used in the startup world to raise money. I mostly see two different reasons cited by startups for their use of convertible notes. First and foremost, they defer the question about your startup’s valuation making it seemingly ideal for early-stage ventures where it’s difficult to properly value a company. Second, it’s usually easier to draft and understand than other forms of venture capital investment.

I’d like to dig into whether avoiding the valuation question is a good idea for you as a startup, but before we do that let’s talk about how a convertible note is usually structured.

Structure of a generic convertible note

A convertible note is a form of convertible debt security; it’s issued by a company in exchange for a loan, sort of like a bond. However, while most bonds pay a coupon, a convertible note usually “converts” directly into equity (which is, ownership stake in the company) when sufficient conditions are met. This gives somewhat decent protection (via liquidation preferences, we will talk about them in a later blogpost) against the downside by the virtue of it being debt, and allows for significant upside participation, since it becomes equity. In the startup world, the conversion usually happens when the next financing round happens.

Notes usually have a maturity date, at which date usually one of three things can happen if the company has not raised its next round of financing yet:

• Automatic Conversion: The notes automatically convert into equity at a pre-determined per-share price or valuation. (There are quite rare)
• The note needs to be paid back. This barely ever happens, since if the startup would have to pay back its note, it would likely bankrupt the company and ultimately, it is possible that the startup may not have the liquidity required to pay back the loan. Neither are preferred situations for the investor, so usually what happens is the following:
• The note is extended. The investor and the company may agree to push back the maturity date by a certain period, usually a year. This can then go on and on as long as the parties can agree on the terms.

Convertible notes often have four major components to them: (I) Valuation Cap; (II) Discount Rate; (III) Interest Rate and finally (IV) its value.

The value

This part of the convertible note is probably the to understand and it is the one most understood by founders. The value of a convertible note is the dollar amount of loan the company receives in exchange for issuing the convertible note to the creditor.

The valuation cap

It’s easy to grasp what the valuation cap means intuitively; it’s effectively a cap on the valuation of your company at its next fundraising round. However, to better understand the motivation behind the term, let’s imagine us as investors who are preparing to participate in a convertible note offering: $XYZ is raising $10M for its seed round and issues a convertible note without a valuation cap. You, the investor, decided to invest, only to find that at the next round, your $10M investment converted into a suboptimal amount of equity. Why? The company raised a round where they raised their valuation to $100B. On paper, your equity is still worth $10M , but you and I both know that the startup is overvalued and you lost out on a great deal of upside.

Now this is all far fetched, but the ability to avoid this situation is the premise of the valuation cap. If the original convertible note had been issued with a valuation cap of $200M, and the company raises money at a $10 per-share price at a $400M valuation, the note would convert at (($200M / $400M) * $10 = ) $5 share price, that is, you’d get 2 million shares. Note that the new investor, if they invested $10M, they’d only get 1 million shares. In essence, the valuation cap is there to guarantee a better upside participation for the investor, in exchange for taking on more risk by investing earlier.

What happens when the next round’s pre-money valuation is less than the valuation cap? Simple, the notes convert at face value into equity.

The discount rate

Strongly related to the valuation cap, the discount rate is another mechanism whereby investors protect their interests. In my opinion, the discount rate is much easier to understand: it’s pretty much a discount the note holder receives on their conversion price in comparison to the new investor’s per-share price.

Suppose that the discount rate is 20%. An investor is investing $10M at a $10 per-share price. If this investment is secured, the convertible note would convert into 1.25 million shares. This is because the discount rate applies to the per share price, so if the new investor invested at $10 per share, the note holder will convert at 80% of $10, that is at $8 per share. Dividing their investment of $10M, we arrive at 1.25M shares.

The typical value of discount rate usually varies from 0% to 35%, but most commonly 20%.

(Some readers may have noted the large amount of shares required to be issued. We will talk about dilution and how to calculate your remaining equity in a future blogpost.)

The interest rate

Most convertible notes will carry an interest rate and this is what qualifies the offering as a debt instrument. There are regulations like usury laws that set a maximum value on it, but the usual is between 2% — 8%. Lower values tend to be in areas where startups are more prevalent, like the San Francisco Bay Area.

It’s important to note that the interest on a convertible is usually not paid in cash or equivalent. Rather, the loan principal is accruing interest and it this amount that will convert into equity. So, if you issue a convertible note for $100 at 5% annual interest rate, at the next financing round (if there is one) the note will be as if it was issued for $105 in the first place.

Generally, the interest rate is there to guarantee a minimum return, even if the startup fails to raise its next round within the set timeline of the note. It is here, where it is important to note that there are alternative forms of investment vehicles, like SAFE or KISS, that offer similar advantages to convertible notes, but are structured in ways that might be more favorable. We will cover them in a later blog post.

Conversion examples

Let’s go over some examples. In the interest of clarity, let’s assume that the interest rate is 0% with all of the following convertible notes.

Discount Rate only

Suppose that the company raises a $10M seed round in the form of a convertible note with 20% discount rate. Shortly after, the company raises a Series A round of $30M for $10 per share.

The discount rate is applied directly to the per-share price of the Series A stock, so the note holders will be able to convert at $10 * 80% = $8 per share. Given their original investment of $10M, that equates to 1.25 million Series A shares.

The Series A investors will receive in total 3 million shares.

Valuation Cap only

Suppose now that the company raised a $200K seed round with a valuation cap of $8M. Soon enough, the company successfully raises a $2M Series A round with a $16M pre-money valuation at $10 per share. Since the pre-money valuation of the company is $16M, which is larger than $8M, the valuation cap kicks in.

To calculate how many shares the note holders will acquire, we first need to calculate the adjustment ratio by dividing the Series A pre-money valuation with the valuation cap: $16M / $8M = 2. We then divide the Series A per-share price with this ratio and we arrive at the final per-share price of the convertible note holders: $10 / 2 = $5. Since they have invested $200K, they will receive 40K Series A shares.

The Series A investors in this case will receive 200K Series A shares.

Discount Rate & Valuation Cap

We’ve seen what happens when either option is used alone by the investors, however what’s more common is that both the discount rate and the valuation cap are set. When this happens, the conversion is determined by the number of shares the investor would get in each option separately and automatically choosing the one where the investor receives more shares.

For illustration purposes, let’s go over a convertible note with both terms set. 12Assume that the company raised its $4M seed round with a convertible note that has a 15% discount rate and an $8M valuation cap. Following this, they raised their Series A with a pre-money valuation of $12M at $12 per-share.

Starting with the discount rate, the note holders’ per-share price will be $10.20, implying they’d receive around 392K shares of Series A stock.

Let’s now compute what would happen if the valuation cap triggered, given a pre-money valuation of $12M and a valuation cap of $8M, the adjustment ratio is 1.5. Thus, the note holders’ per-share price would $8 and they’d receive 500K shares.

To recap, applying the discount rate, the investors would end up with around 392K shares, while applying the valuation cap they’d receive 500K shares. Thus, the valuation cap method is used and the investors receive 500K shares of Series A stock for their seed investment of $4M.

Closing thoughts

We’ve covered the main aspects of convertible notes, but there is still a lot left. I have blog posts planned that cover how the dilution works, how it relates to the Employee Stock Option Pool and about the alternatives to convertible notes.

I do hope this is useful and let me know if you have any feedback, I appreciate you reading this far.

Best.