Convertible notes are a form of short-term debt that allow seed investors to loan money to a startup company in its earliest stages. Instead of being paid back the principal plus interest at a maturity date, the investor will use the principal for a deal on equity in the startup. Typically, the convertible note will convert into equity during the next round of investing.
Benefits of Convertible Notes
Often, convertible notes are used at the early stage of a company’s life. However, they do come up in later stage financings as well. But, one benefit of issuing convertible notes from the issuing company’s perspective is that the company doesn’t need to create a valuation for the company at the time of issuance. Instead, the note typically provides that the note can/will convert when there has been a “qualified financing” (i.e., an equity raise with a specified threshold of new capital). Thus, the company gets to take on investment now, but “punt” the valuation question down the road. Then, when the “qualified financing” occurs, the valuation of the company’s equity occurs. Typically, this is a later part of that early stage where the business model may be coming together and the company can put together a clearer picture of the future finances of the company.
Another benefit of the convertible notes is that, until the “qualified financing” occurs (or the note is converted in some other fashion, the investors are just lenders to the company and are not entitled to typical shareholder rights (which could include a vote on company matters).
To reward the note holder for investing in the company at such an early stage, the company will usually provide a “valuation cap” and/or discount on the conversion price.
A valuation cap works like this: say you invested $100,000 into a company and agreed with the company’s founder that the current value of said company cannot be more than $5 million. So, $5 million would be the valuation cap.
In the “qualified financing”, the company’s estimated valuation jumps to $10 million. The terms of the note would provide the investor the benefit of converting as if the company were worth $5 million, instead of the $10 million. In this case, the note holder would get twice the number of shares than it would if the valuation cap were not part of the terms.
When the math isn’t so simple, you can divide the valuation cap by the valuation in the “qualified financing” and then multiply that by the price per share. The result of that equation will give you the discount on the share price paid by other investors in the “qualified financing”.
Discounts on Conversion
Some notes have both discounts and valuation caps. But, if there is only one of these terms, it’s often the discount.
Using the same example from above, except that this time, let’s assume that the company did not offer a valuation cap to note holders, but instead offered a 20% discount on stock in the next round of investing. If the price per share in the “qualified financing” comes to, say $5.00 per share, then the noteholders would get to convert their debt into equity at a price of $4.00 per share (i.e., $5.00 * (1-.20)).
As is often the case, business owners will include both valuation caps and discounts in convertible notes. If you are intrigued by the convertible note concept but want to ensure your legal stability, contact Doida Law Group and we will be happy to provide experienced and competent legal counsel for your startup. We can also provide some data on what are “market terms” for these instruments.