%% Source: https://fastercapital.com/content/The-Pros-and-Cons-of-Issuing-Convertible-Notes.html#Convertible-notes-and-their-benefits https://www.toptal.com/finance/startup-funding-consultants/convertible-note %% Here's how convertible notes work: - A convertible note allows startups to raise money from investors in the form of a loan with a fixed interest rate. - The note comes with a maturity date, by which time the startup must (theoretically) return the principal amount plus interest back to the investor. - The loan accrues interest over time until the maturity date. This interest is not repaid, but just added to the principal. - Upon a qualified financing round (like a Series A), a convertible note can be converted into equity in the startup. If the startup's equity is worth more than the value of the loan, the investor can convert the principal plus accrued interest into shares of preferred stock. - Conversion of the debt to equity is usually done at a predetermined discount rate and/or a valuation cap. - The discount rate gives investors a lower price per share when converting, rewarding them for investing earlier when risks were higher. For example, a 20% discount rate means if new investors pay $1 per share, the note investor gets a discounted $0.80 per share. A discount rate of 20-30% is common. - The valuation cap sets a maximum valuation for the conversion, providing a lower-priced share for the investor if the actual valuation exceeds the cap. For instance, a $6M cap may override a $8M priced round valuation. Without the valuation cap, if the startup does very well after raising money from note holders and raises a giant priced financing round, the note holders will be crushed to an extremely low equity position. The valuation cap ensures that the convertible note holder is guaranteed to hold a minimum amount of equity. A valuation cap of $1.5 million - $ 5 million is common. - If the convertible note contains both a valuation cap and a conversion discount, the note holders can choose whichever option gives them the best deal (the lower price per share). - If the startup does not raise a priced round by the maturity date of the convertible note, one of three things can happen: - Extend the maturity date: The most common approach is for the startup to negotiate an extension of the maturity date with the note holders, giving the company more time to raise a priced round and trigger conversion of the notes into equity. This is often in the best interest of both parties, as the investors still have the potential for equity conversion and the startup avoids defaulting on the debt. - Repay the note: The startup can repay the outstanding principal and accrued interest to the note holders, effectively ending the investment relationship. However, this is usually an undesirable option for cash-strapped startups and means the investors miss out on potential future gains. - Convert to equity: In some cases, the startup and note holders may agree to convert the debt into equity shares even without a priced round, based on a pre-agreed or negotiated valuation. Note: The discount rate and valuation cap are negotiated to incentivize investors to fund the startup during its riskier early stages. They provide a way for early investors to get more shares at a lower price per share compared to later investors in priced equity rounds. This rewards early investors for taking on more risk. From the startup's perspective, these terms help attract investor capital when they have no other option to raise funding. Here are a few examples to illustrate how a conversion discounts and valuation caps work: ``` Example 1 (No Conversion Discount or Valuation Cap): - Startup raises $100,000 via a convertible note from an investor. - In the next priced equity round (e.g. Series A), the startup raises $1 million at a $5 million pre-money valuation, with a share price of $1 per share. - With no conversion discount, the $100,000 convertible note simply converts to 100,000 shares ($100,000 / $1 per share). ``` ``` Example 2 (With 20% Conversion Discount, No Valuation Cap): - Same scenario, but the convertible note has a 20% conversion discount. - The new $1 per share price is discounted by 20%, so the convertible note investor gets to convert at $0.80 per share. - This means the $100,000 note now converts to 125,000 shares ($100,000 / $0.80 per share). The note holder gets 25% more shares (125,000 vs 100,000) compared to no discount. ``` ``` Example 3 (With $4 Million Valuation Cap, No Conversion Discount) - Same $100,000 convertible note, no discount. - But note has $4 million valuation cap. - At $5 million pre-money valuation, there would be 5 million shares ($5M / $1 per share). - But $4M cap means only 4 million shares at $1 per share. - So $100,000 note converts to 200,000 shares (($100,000 / $4M) * 4M shares) The note holder gets 100% more shares (200,000 vs 100,000) compared to no valuation cap. ``` ``` Example 4 (With 20% Discount and $4 Million Valuation Cap): - $100,000 convertible note - 20% conversion discount - $4 million valuation cap - Priced round raised at $5M pre-money valuation Calculating with 20% Discount: - Effective price per share = $0.80 - Note converts to 125,000 shares (see Example 2). Calculating with Valuation Cap: - Note converts to 200,000 shares (see Example 3) - Effective price per share = $0.50 ($100,000 / 200,000 shares) The note holder gets more shares when exercising the valuation cap. ``` #### Other Terms in a Convertible Note - **Ability to Pre-Pay**: the startup may or may not be allowed to pre-pay the loan back to the investor instead of allowing the investor to convert the loan into equity. - **Rights Upon Acquisition**: usually the investor will be paid back extra upon an acquisition of the startup by another company; - **Warrants or Other Future Rights**: to entice investors to take a risk on an early-stage startup, the investor will sometimes receive warrants that allow the investor to purchase additional stock at a future date. #### Advantages %% https://fundersclub.com/learn/guides/understanding-startup-investments/convertible-securities/ %% Advantages for Startups: 1. Defers Valuation: Convertible notes allow startups to raise capital without having to firmly establish a valuation upfront, which can be difficult in the early stages when future growth is uncertain. 2. Faster and Cheaper: Convertible note rounds typically close more quickly and require less legal documentation (5-6 pages) compared to priced equity rounds (300+ pages), resulting in lower legal fees. 3. Delays Complex Negotiations: Convertible notes allow startups to delay negotiating complex terms like dividends, voting rights, liquidation preferences, etc. until a later priced equity round. 4. Bridges Funding Gap: Convertible notes provide an easy way for startups to bring in funding through a simple debt instrument between larger priced equity rounds. 5. Avoids Debt Burden: Unlike typical debt, convertible notes are intended to convert to equity rather than be repaid with interest, avoiding debt repayment obligations for cash-strapped startups. Advantages for Investors: 1. Early Entry: Convertible notes allow investors to get into promising startups early, before a priced equity round, and help shape the company's growth. 2. Early Investment Premium: Investors can negotiate for conversion discounts and valuation caps when their notes convert to equity in a later round, rewarding them for early investment. 3. Simplicity: Convertible notes are relatively simple compared to priced equity rounds, with less legal documentation and due diligence required upfront. 4. Defers Complex Negotiations: Like startups, investors can defer complex negotiations on terms like board seats, liquidation preferences, etc. until a later equity round. 5. Higher Priority of Repayment During Bankruptcy: If the startup fails before the note converts to equity, convertible note holders (which is a form of debt) are entitled to be repaid before any of the equity holders, giving note holders a higher likelihood of recouping their investment. #### Disadvantages Disadvantages for Startups: 1. Debt Obligation: Convertible notes are debt instruments that create repayment obligations with interest if the company fails to raise a priced equity round before the maturity date. This adds risk compared to equity financing. [](https://legalvision.com.au/pros-and-cons-of-convertible-notes-an-investors-guide/)[](https://legalvision.com.au/pros-and-cons-of-convertible-notes-an-investors-guide/)[](https://fastercapital.com/content/The-advantages-and-disadvantages-of-convertible-notes.html)[](https://managementstudyguide.com/pros-and-cons-of-convertible-notes.htm)  2. Interest Burden: Convertible notes typically have higher interest rates than traditional debt financing, increasing the financial burden and reducing cash available for operations and growth. [](https://fastercapital.com/content/The-Pros-and-Cons-of-Issuing-Convertible-Notes.html)[](https://fastercapital.com/content/The-advantages-and-disadvantages-of-convertible-notes.html)[](https://managementstudyguide.com/pros-and-cons-of-convertible-notes.htm)  3. Delays Future Funding: Having outstanding convertible notes can delay a startup's ability to raise additional equity funding rounds, as investors may be hesitant to invest with debt on the books. [](https://fastercapital.com/content/The-Pros-and-Cons-of-Issuing-Convertible-Notes.html)[](https://managementstudyguide.com/pros-and-cons-of-convertible-notes.htm)  4. Valuation Pressure: Given the conversion discount and valuation caps in convertible notes, startups may be pressured to achieve a high valuation in the next equity round to avoid unfavorable conversion terms and dilution for existing shareholders. This may have other [[The Risks of Seeking the Highest Valuation|downstream implications]]. [](https://fastercapital.com/content/The-Pros-and-Cons-of-Issuing-Convertible-Notes.html)[](https://fastercapital.com/content/The-advantages-and-disadvantages-of-convertible-notes.html)  5. Potential Dilution: If notes convert after a future equity round, it can lead to significant dilution for founders and existing shareholders, especially without a valuation cap. [](https://legalvision.com.au/pros-and-cons-of-convertible-notes-an-investors-guide/)[](https://fastercapital.com/content/The-advantages-and-disadvantages-of-convertible-notes.html)[](https://managementstudyguide.com/pros-and-cons-of-convertible-notes.htm)  6. Complex Terms: While simpler than priced rounds, convertible notes still require negotiating terms like discounts, valuation caps, interest rates etc., adding legal complexity. [](https://legalvision.com.au/pros-and-cons-of-convertible-notes-an-investors-guide/)[](https://fastercapital.com/content/The-advantages-and-disadvantages-of-convertible-notes.html)  Disadvantages for Investors: 1. Risk of Financial Loss: If the startup fails before the notes convert, there may be no funds left to pay note holders after repaying preceding debts like bank loans. [](https://legalvision.com.au/pros-and-cons-of-convertible-notes-an-investors-guide/)[](https://managementstudyguide.com/pros-and-cons-of-convertible-notes.htm)  2. Lack of Control: Convertible note holders are not yet shareholders, so they do not have voting control or voting rights until the note's conversion to equity. [](https://legalvision.com.au/pros-and-cons-of-convertible-notes-an-investors-guide/)  3. Valuation Uncertainty: There is uncertainty around the investor's eventual ownership percentage and return until notes convert in a later priced equity round. [](https://legalvision.com.au/pros-and-cons-of-convertible-notes-an-investors-guide/)[](https://fastercapital.com/content/Advantages-and-disadvantages-of-convertible-notes.html)  4. Potential Dilution: Without a valuation cap, a high valuation in the next equity round can significantly dilute the investor's ownership stake. [](https://fastercapital.com/content/The-Pros-and-Cons-of-Issuing-Convertible-Notes.html)[](https://fastercapital.com/content/The-advantages-and-disadvantages-of-convertible-notes.html)