How Convertible Notes Work
One of the most common methods used to invest in early stage startups is something called a convertible note. A convertible note is a loan that converts into equity after the company has a bit more operating history under its belt and there is more information available to establish a fair price.
Why use a convertible note?
Convertible notes are often used for seed rounds (the first investment money taken by a startup) because they delay the difficult task of deciding how much the company is worth to a later point in time when it is easier to do so. How much would you say that 2 software engineers and a prototype is worth? How would that change if there was an MBA on the team? By investing through a convertible note, these decisions can be delayed until a company has a track record of users or customers that make it clearer what a fair price should be.
How does a convertible note work?
When you invest through a convertible note the startup receives the money right away, but the number of shares you are entitled to is determined during its next round of financing, or Series A. At that point the company will have some operating history that more experienced angel investors or venture capitalists can review in order to determine a fair price. Once the series A investors have determined a price, your loan converts into shares at a discount to the series A price to reward you for the additional risk you took on by investing early.
The amount of equity that a note converts into depends on the price of the A round plus 2 key components of the your note.
- Discount Rate: The discount rate establishes how much you will be compensated for the additional risk you take on by investing in a company before the series A investors. For examples, if you invest using a note with a 20% discount rate, and the A round investors wind up investing at a price of $1/share, your note will convert into equity at $0.80/share and you will receive 25% more shares for the same price.
- Valuation Cap: The valuation cap is another way to reward seed stage investors for taking on additional risk. The valuation cap sets the maximum price that your loan will convert into equity. To translate that into a share price, you divide the valuation cap by the series A valuation. Lets say you invest in a startup using a note with a $3 million cap. If the series A investors decide that the company is worth $6 million dollars and pay $1/share, your note will convert into equity AS IF the price had actually been $3 million. By dividing $6 million by $3 million we get an effective price $.50/share. That means that you will get twice as many shares as the series A investors for the same price.
How the discount rate and valuation cap interact
Convertible notes generally convert using the the discount rate OR the valuation cap, whichever gives the investor a better price. Lets say the note has a $3 million cap with a 20% discount and the company receives a $6 million series A valuation at $1 a share. In this case using the discount rate would yield a price of $1*.8 = $.80 a share, and using the valuation cap yields a price of $3 million / $6 million or $.50 a share. $.50 is a better price so we use the valuation cap. If the series A valuation had only been $3.5 million at $1 a share using the discount rate still gives us a price of $.80, but using the valuation cap give us a price of $3 million / $3.5 million or $.86. In this case $.80 is a better price so we use the discount rate. It is important to note that the discount rate and valuation cap do not both apply, only the method which results in the best price for the investor.
Two more important components of convertible notes
- Interest Rate: Convertible notes are technically loans so they also carry an interest rate. Unlike traditional loans however this interest is paid in additional shares upon conversion of the note instead of cash. Let’s say you invest $1,000 in a startup through a convertible note with a 5% interest rate. If they receive a series A investment one year later, you would have accrued $50 worth of interest and would be entitled to $1,050 worth of shares at the appropriate conversion rate.
- Maturity Date: The note’s maturity date determines when the note is due, and the entrepreneur needs to repay it. If a startup is unable to raise a series A, or is profitable enough to make it unnecessary, the convertible note will convert into a set number of shares. This will generally be the same as if the startup had secured a Series A investment at the maturity date. For example, lets say you invest $2000 in a startup with a 24 month maturity date, a 20% discount, a $4 million valuation cap, and a 5% interest rate. Assuming shares are worth $1, after 24 months your note would convert into: $2000*1.2 = or $2,400 after the discount, plus 5% interest for 2 years = $100 so a total of $2500 worth of stock.
How do I know if the deal is fair?
It is hard to determine if convertible note terms are fair when you do not have much investing experience. Ideally an experienced investor will already have invested in the company and set the terms. If not, you should look at startups with similar teams and traction, and see if the startup you are evaluating has similar terms.