We often receive questions from our investors about convertible notes – what they are, how they work, and why they’re used. Here’s a quick run-down of what you should know about the convertible note funding structure, as well as how and why they’re used.
What is a Convertible Note?
When it comes to issuing securities to raise money, entrepreneurs have two options: debt or equity. Debt is a loan that their company must pay back within a set period of time, plus interest. Equity is when the company offers a portion of ownership in exchange for the investment.
A convertible note is a loan that converts to equity at a pre-determined maturity date or company milestone, oftentimes a financing event outlined within the note’s investment documentation. A convertible note sometimes referred to as simply a “note,” is debt with the potential to become equity.
Something important to understand about convertible notes is that they are not reflective of nor do they determine the valuation of a company, unlike equity ownership (a key distinction between the two). It’s often difficult to determine the valuation – and thus the equity – of a startup company. Convertible notes offer an opportunity for early investment and essentially “kick the can” with respect to pricing equity to the next round of investors.
Key Features of Convertible Notes
Convertible notes have five key features:
Typically, convertible notes are structured as 18-24-month loans given by investors to small businesses to help them ready their company for the next round of funding, optimally led by a venture capital firm. The maturity date is the date that the convertible note converts from a loan (debt) to equity ownership.
A conversion milestone is the set marker that prompts the conversion of the note from debt to equity. Most often, this involves an equity financing event, again, optimally backing from a large VC firm or institutional investor, who will then set the terms of the next round of funding.
A discount rate is given to early investors as an incentive to take on risk. Essentially, it is the discount given to investors when the convertible note converts from debt to equity. Generally, a note converts at a discount of 20%, relative to the conversion price set for later investors.
For example, an early investor makes a $1,000 investment with a discount rate of 20%. Later down the road, a later investor also makes a $1,000 investment (without receiving the discount rate). Then, the conversion event happens. The next round of financing is secured, and a conversion price set at $10/share. The early investor gets 125 shares in the company, while the later investor only gets 100 because they didn’t get the discount rate.
A valuation cap, or just “cap,” is a pre-set max valuation on a company in which the investor agrees to convert their shares. In the chance that the valuation of a company dramatically increases in the next round of financing, caps are used to protect early investors. Basically, caps ensure the investor will get to convert their investment at the cap. A good rule of thumb with caps is that the lower the cap, the better the deal. The higher the cap, the worse the deal.
Say an early investor agrees on a $2M cap with the company. Later on, institutional investors value the company at $5M. The early investor would convert their shares at the pre-agreed upon $2M valuation rate, seeing a return on their investment.
Interest rates on convertible notes are calculated via simple interest, which excludes the effect of compounding. Interest is not paid out during the life of the loan; rather, it accrues and is paid out on the maturity milestone. Interest rates on convertible notes usually range between 5-7%, but can also be 0%. Upon conversion to equity, the full principal loan amount as well as any accrued interest converts with the loan.
Convertible Notes vs. Equity
Equity is quite straightforward: a company is given a pre-money valuation from which a share price is determined. Going in, investors know what the terms are and how many shares they will own in that round.
- A company has a pre-money valuation of $4,000,000 with 2,000,000 shares. The price per share would be $2.
- An investor makes a $500,000 investment, receiving 250,000 shares.
- The post-money valuation of the company would be $4,500,000, meaning the investor owns exactly 11.11% of the company.
When & Why Convertible Notes are Used
Most often, convertible notes are used in early-stage investment rounds. They are also frequently used as “bridge loans,” filling the gap between additional funding rounds. As we mentioned earlier, it is difficult to establish valuation and price equity for a startup company. Additionally, bridge rounds, unlike Series A, B, and C rounds, do not require that there be a valuation set for the company. This can advantageous for convertible note investors if a subsequent equity financing round does occur and valuation is set by an institutional investor or venture capital firm – they typically have more leverage when it comes to setting terms.
Regulation Crowdfunding & Crowd Notes
Raising small amounts of money from large numbers of people can present significant challenges for very early-stage startup companies. Specifically, how does a startup focus on its core business operations while also providing information to, soliciting and recording shareholder votes from, and satisfying reporting requirements for large numbers of investors?
Enter the crowd note, a modified convertible note designed specifically for crowdfunding investing. The key differentiating feature between a convertible note and a crowd note is the maturity date; a crowd note does not have one. Other differences include limited voting and information rights, the potential to extend the crowd note after locking in an initial conversion price, and provision for a corporate transaction payout – investor protection against an early exit.
The goal of these modifications is to allow for multiple very early stage investors while also minimizing “noise” on a company’s capitalization table, which can be a deterrent for later institutional or venture capital investors.
For early-stage companies, convertible notes can be an attractive option because they prevent the issuer from being forced to determine the value of the company prematurely. In many cases, the company could still be an idea in the works, and there likely isn’t enough information available yet to determine a fair valuation.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.