Convertible Note Basics
This post isn’t intended to get into all the details of convertible note mechanics. But I get enough questions about when to use them and what the basic components are that I thought a basic primer was in order.
When To Use – Convertible notes are a form of financing (fundraising) that are most commonly used in the earliest stages of company formation when the value (valuation) of the company is impossible or undesirable to establish. Setting a valuation for a company in the early stages is already part art and part science but in the earliest stages it is almost all art. Actually, it’s purely the intersection of how much equity (ownership) the founders are willing to give up and how much equity the investor demands for their investment. Some investors refuse to invest via convertible note because of the future uncertainty of how much equity they will eventually receive (explained in next section) while other investors have no issue with this fundraising instrument. It is somewhat of a religious debate.
What Does It Convert To – A convertible note is a form of debt (a loan). But instead of making regular payments to pay off the debt, the amount of the note “converts” to equity at a point in the future and as dictated by the various terms of the note. The class of equity shares granted per the conversion are the same as whatever the new equity investors are granted, which almost certainly means Preferred shares (versus Common shares). If the triggers for future conversion aren’t met, sometimes regular loan payments are triggered and sometimes conversion to equity happens anyway. But simply paying off the loan with interest isn’t the intent or hope for either the company or the investor.
Standard Terms – The following terms are almost always included in a convertible note:
- Conversion Triggers – Convertible notes almost always convert based on a length of time (aka “term” or “maturity date”) or the amount of money raised in a future equity round, whichever comes first. The length of time is usually in the 1-2 year range while the trigger for the amount of money raised in the future is generally 2-3 times the amount to be raised on the note. In other words, if you’re raising $350K on a note you might set a conversion trigger on raising $750K to $1M in a future equity round (you will need to pick a specific number). Also realize an especially long term or large dollar amount trigger might force you to be more liberal on the other terms because the note holders want to convert to equity within a reasonable amount of time.
- Discount – It’s not fair that the early investors convert their invested amounts at the same valuation as the future investors. After all, the money from the early investors came at a time when the company’s viability was more risky and their investment facilitated company growth and other valuation-driving milestones. So the way to compensate for this is to give the convertible note investors a discount against the future valuation upon conversion. Common discounts are in the 15-20% range with 20% being most common. So if the company valuation during your equity-based fundraising round is $5.0M and you offer a 20% discount, the convertible note investors will get equity based on a $4.0M valuation (20% off $5.0M). To get specific, a $50K convertible note investor will get 1.25% equity (versus 1.0% if they didn’t get the discount).
- Interest Rate – Like any form of debt, a convertible note carries an interest rate. The interest accrues until either the conversion takes place or the note is paid off. For a conversion, the interest is added to the initial investment before calculating how much equity to give. In other words, a $50K investment would convert at a value of something like $53-58K depending on how much time goes by before conversion.
- Principal Amount – Sometimes there is a stated limit to how much can be raised on the note. This might be referred to as the “aggregate principal amount” or might be described in a section labeled “closings” or “subsequent closings”. The objective of this term is to inform the investors how much you might raise in a particular round. It’s not a bad idea to give yourself some flexibility by stating a number that’s 20-25% higher than you actually need to raise. It doesn’t mean you have to raise that much. And you probably don’t want to double your needed amount because that sends a completely different signal to the investors regarding your intentions and they might draw conclusions based on it. For example, a startup that raises excessive amounts on a convertible note might be faced with significant dilution upon raising the future equity round that causes the notes to convert. As a result, the founders might not control the company and some investors might not be comfortable with that situation so early in the company’s evolution.
- Valuation Cap – What if the early-stage investments from convertible note investors allows the company to fly like a rocket ship and reach a valuation of something like $10M before raising an equity-based round? It seems unfair that the convertible note investors convert at a $8.0-8.5M valuation (assuming 15-20% discount). So to offset this risk to the investors, it’s not terribly uncommon to see a valuation cap to protect them. Using an example of a $4M cap, if the company is able to raise money from future equity-based investors at a valuation higher than that, the convertible note investor’s investment converts assuming the valuation was only $4M. They would have been offered a discount anyway, so with a 20% discount the investor only comes out favorable in this cap example if the company raised their future equity round at a valuation higher than $5M (20% discount off $5M = $4M).
- If you’re struggling to decide how to set the cap or are getting pushback from investors that it’s too high, see my related blog post titled “Justifying the Cap Amount in Your Convertible Note“.
- Early Exit Multiple – If included, this is described in a section usually labeled “change of control”. What if the company skyrockets and ends up selling the company for decent amount of money before the term limit on the note and without ever needing to raise an equity round that would cause the conversion? It seems unfair that the early investors only get their initial investment back plus any accrued interest. So to reward the convertible note investors, it’s not uncommon to see an early exit multiple. 2X is fairly common for this (in other words, they double their money). An alternative is to give the investor an option to convert to equity at the stated cap amount immediately prior to the acquisition, if this is more favorable than the early exit multiple.
Convertible notes are less complicated and therefore less costly to put together for the company. You don’t need to spend a lot of money on legal fees to put together a fundraising round using a convertible note. There are online, open source templates if you’ll do a search. Make sure you understand everything in the template and at least get a legal review before considering it final. Pay special attention to what options the investors have if the term length is reached without a natural conversion. And if you want to educate yourself on other aspects of venture financing, buy the book Venture Deals by Brad Feld and Jason Mendelson. You can find it here on Amazon.