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March 27, 2020

What is a Convertible Note?

 

What is a Convertible Note?

A convertible note is a form of financing for early-stage startups. Because it’s a rather popular form of financing, we thought it would be pertinent to cover this security. As its name implies, convertible notes are a form of short-term debt that converts into equity in the future, normally in conjunction with a future financing round. Convertible notes differ from traditional notes or loans. When investors loan money, they receive equity in a company rather than the principal plus interest. 

 

Convertible notes are popular forms of financing for early-stage startups. They allow founders to delay assigning a specific valuation number during the early stages of their company’s life. A few key components of a convertible note to consider are: discount rate, valuation cap, interest rate, and maturity date.

 

  • Discount Rate: the discount rate represents the valuation discount convertible note investors receive relative to investors in future financing rounds. Discount rates compensate early investors for the additional risk they bear for investing earlier.

 

  • Valuation Cap: the valuation cap on a convertible note (and on a SAFE) caps the price at which investors’ notes will convert into equity. Convertible notes, however, can be uncapped in which case the interests of the noteholders and the issuer are misaligned – holders want as low a valuation cap as possible while issuers want as high as possible.  Valuation caps are an additional reward to investors who invest early in a company’s life. 

 

  • Interest Rate: since convertible notes are hybrid debt-equity instruments, convertible notes will accrue interest as well. Instead of accruing an investor’s cash back, however, the interest accrues to the principal invested. This increases the number of shares issued upon conversion. 

 

  • Maturity Date: as you might guess, this indicates the date on which the note is due, at which time the company needs to repay it.

 

Convertible Note Examples

  • Valuation cap, no discount: 

Company X raises a seed round by issuing a convertible note on a $4M valuation cap and no discount. Some time later, Company X raises its Series A at a $16M pre-money at $10 per share. To calculate the price per share for convertible noteholders, you would divide the valuation cap on the note by the pre-money valuation of the subsequent round and apply that to the Series A price per share. That works out to $2.50 per share ($4M/$16M * $10) for convertible noteholders. 

  • No valuation cap, with a discount: 

We’ll use the previous example where Company X raises a seed round by issuing a convertible note with no valuation cap, but a 20% discount on a future Series A round. When Company X raises its Series A, the pre-money valuation is of no importance, only the price per share. Let’s again assume $10. Applying the 20% discount to the $10 price per share yields $8 per share for convertible noteholders.

 

  • Valuation cap and a discount: 

To continue the previous examples, let’s say Company X raised a seed round by issuing a convertible note with a $4M valuation cap and a 20% discount. In cases where there is a valuation cap and a discount, investors receive the lower between the two provisions. If we take our first example of a future Series A pre-money valuation of $16M at $10 per share, the investor would receive shares at $2.50 per share instead of the $8 per share as the valuation cap results in a lower price per share.

 

  • Valuation cap and a discount conversion:

For our final example, Company X raises a seed round by issuing a convertible note with a $4M valuation cap and a 20% discount. In this example, however, when Company X raises a Series A, their pre-money valuation is $4.5M. In this case, the investor would receive the $8 per share discount provision as it is lower than the valuation cap provision which results in $8.89 per share. 

 

It’s important for entrepreneurs and investors to realize the pros and cons of convertible notes. Convertible notes are simply structured and also allow entrepreneurs to delay putting a formal number on their valuation. However, they can hamstring investors and entrepreneurs alike. For the investor, convertible notes provide little of the control they would normally receive with preferred stock. For the entrepreneur, if your company takes off like a rocket ship, your Series A valuation may skyrocket. Subsequently, this would grant convertible noteholders a too beneficial price per share. As such, issuers of convertible notes need to find the right balance between the various components found in convertible notes.

 

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About: Francis Vu

An investment professional with a background in private equity and venture capital having spent time conducting investments at VU Venture Partners and Pacific Oak LLC with a finance and management degree from Tulane University.

View Francis Vu's articles

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