How Do Convertible Notes Work For Early-stage Financing
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How Do CONVERTIBLE NOTES Work For Early-stage Financing
Transcript of How Do Convertible Notes Work For Early-stage Financing
How Do
CONVERTIBLE NOTES
Work For Early-stage Financing
What are convertible notes?A convertible note is:
A financial instrument used for investments in early stage companiesA short-term debt that converts into equity at a trigger event A short-term debt that converts into equity at a trigger event
Frequently used in bridge financing
Suitable for quick finance injections rather than full financial rounds
Best of both worlds
Note holders enjoy the downside protection typically given to debt lenders, but is also positioned to enjoy the upside opportunity presented to equity holders
A convertible note-holder enjoys
more protection than equity
holders in case the company is
forced to wind up
If the company raises money in a subsequent round,
the note-holder converts to equity
holder
Convertible debt is different from equity
In case the company takes off debt-holders can
convert to shareholders
In case of liquidation, debt-holders get their
money back before
shareholders do.
SENIORITY SPECIAL RIGHTS
The Trigger Event
*Some contracts have the option to ask for repayment at expiration rather than shares
Subsequent funding round
Take over/sale
Liquidation
Expiry date of the convertible note
Convertible note has a series of triggers for
conversion
Basic terms to agree on
INTEREST RATE DISCOUNT CAP
The interest rate is denominated on a yearly basis. This rate is usually between 4% and 8% from point of signing until the note is converted. As opposed to being paid back in cash, this interest accrues to the principal invested, increasing the number of shares issued upon conversion
Debt-holders convert at valuation minus the discount.In the case of an early investor, applying the discount compensates the investor for the additional risk he bore by investing earlier
Basic terms to agree on
INTEREST RATE DISCOUNT CAP
The cap is the maximum valuation debt-holders can convert at.
The effect of the cap is that convertible note investors usually pay a lower price per share
compared to other investors in the equity round. Note-holders convert at valuation equal to cap
*(1-discount)
Basic terms to agree on
INTEREST RATE DISCOUNT CAP
How to price the convertible notes?
In principle, the higher the valuation at the trigger event, the lower the equity stake for the convertible note holders, unless the valuation is above the cap.
Investors will keep the cap low and the discount high, while you and the founding team will
strive for the opposite.
How will it affect your cap table?Convertible note
Cap = $4MDiscount = 20%
Price of convertible note= $120,000 Investment amount = $1M
Trigger round
Pre-money valuation = $12M
*Values are calculated with the Equidam Convertible Note Calculator
What discount would you give to investors?
Distribution of discount rates by users on Equidam’s Convertible Note Calculator
The average Discount Rate for a Convertible Note is
32,59%
Myths of Convertible Notes
It is difficult to issue convertible debt that is not part of a round, because investors are aware that your company probably needs more money than they are offering. In case the convertible note is part of a round, most of the investors will not invest unless everyone else commits and you reach
your funding goal. So the immediacy is lost.
Negotiations over the cap raise the issue of valuation all over again.
You need to get the approval of all current shareholders, which is quite expensive, since you need certification of a notary.
QUICK TO ISSUE
CHEAP TO ISSUE
DEFERS THE VALUATION CALCULATION
Additional Resources
How Do Convertible Notes Work? [Infographic]
Average Discount Rate For A Convertible Note [Video]
Convertible Debt: Risks And Terms To Be Aware Of [Video]
Convertible Debt Vs Equity Financing [Video]
