Startups 101 – Convertible Notes

Jake Askew – Cannon Ventures

Fundraising can be the most challenging aspect of starting a company. And in those early stages, there are times  when a founder might run into the need for additional capital sooner than expected. Rather than jump straight into a Series A round of fundraising and the level of work and commitment that goes along with that, entrepreneurs have options. Perhaps the most common (and commonly misunderstood) of those options? A convertible note. Below is a quick overview to help give first-time founders a big picture viewpoint on this potentially beneficial platform.

Convertible Note vs. Equity Round

To start with, the most common reason an entrepreneur would go this route would be that the company is not in a position to establish a fair valuation. A clean valuation is important for a company because that determines a price per share of stock that an investor might consider purchasing. However, if the company is still too early along to reach a proper valuation, a convertible note can be used instead, essentially punting the decision on valuation until the company is ready for a legitimate Series A round. Also, called “qualified financing,” the eventual Series A round will then convert the note into shares of equity.

Another reason to utilize a convertible note might be that the amount needed to raise is not high enough to justify the time and effort needed to complete a full Series round of financing. Or, convertible notes can be useful if a company needs capital quickly to either add a key hire to the company, complete an unexpected inventory order, or make a push in one area like marketing or legal.

  • Discount Rate – The discount in valuation you will receive in the next qualifying round of financing. A convertible note rewards early stage investors by allowing them to convert at a lower valuation than that reached through a subsequent financing round.
  • Valuation Cap – A conversion valuation cap (sometimes referred to as just a “cap”) is another reward for a noteholder for taking on additional risk by investing at an early stage company. The valuation cap states a maximum valuation for a qualified financing round. For example, if the valuation cap is set at $4M and the subsequent round of financing values the company at $6M, then the noteholders will convert at a valuation of $4M.
  • Interest RateBecause convertible notes are technically loans, they also carry an interest rate. However, unlike traditional loans, this interest is paid in additional shares upon conversion. Consider a noteholder investing $1,000 into a startup with a 5% interest rate. If they reach a round of qualified financing a year later then they would have accrued $50 worth of interest and be entitled to $1,050 worth of shares.

  • Maturity DateA note’s maturity date states when the note is due and the entrepreneur needs to repay it. If a round of qualified financing occurs before this date then the note converts at that time.

Convertible Note Example

As noted, the “convertible” portion of Convertible Note” means that it will convert using the discount rate or the valuation cap, whichever gives the investor a better price.

  • Discount Rate – Let’s say that a note has a $5M cap with a 20% discount and the company receives a $10M series A valuation at $1 a share. In this case, the discount rate would yield a price of $1*.8 = $.80 a share, while using the valuation cap yields a price of $5M / $10M = $.50 a share. $.50 is a better price so the noteholder will convert at a price of $.50 per share rather than the $.80 per share.
  • Valuation Cap – Now let’s say that the Series A round of financing instead valued the company at $6M at $1 per share. The discount rate would still yield a price of $.80 per share for the noteholder, however the valuation cap would yield a price of $.83 per share. In this case the discount rate gives the noteholder a better price so that is what the note will convert to.

Early startups face numerous challenges every day, and fundraising is certainly one of them. Convertible notes aren’t always the solution, but they do give founders a new option to keep the momentum of their early stage company moving forward.

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