Convertible Notes 101

You are looking to raise financing and a potential investor offers to provide a convertible note in lieu of a direct equity investment, but what exactly does this mean?

A convertible note or loan is essentially a loan that can be converted into shares. It typically comprises of the following terms:

Automatic Conversion: The loan amount will automatically convert into shares upon receipt by the company of a certain investment amount – a qualified financing (e.g. $2 million).

Voluntary conversion: If the company secures less than a qualified financing (e.g. $1 million), the lender will have the right (but not the obligation) to convert the loan amount into shares.

Discount/Cap: To compensate the lender for taking the risk of investing at such an early stage, convertible notes will typically convert at either a discount on the next round (20-30%) or a capped company valuation, or the lower of the two options. In other word the lender will participate in the later financing on more favorable terms than the new investors.

This is easiest to explain by way of an example.

Let’s say that the company raised $1 million under a CLA with a $5M valuation cap or 20% discount (whichever is more favorable to the lender).

It then raised $3 million by way of an equity investment at a pre-money company valuation of $8M and a price per share of $10. The loan would now automatically convert, but at what price?

If the lender uses the 20% discount, instead of paying $10 per share he will pay $8 per share.

If the lender uses the valuation cap he will invest as if the company is worth $5 million (not $8 million). This would work out at a price per share of $6.25.

In this scenario the cap provides more favorable terms to the lender, as he will be issued more shares upon conversion.

A conversion cap can be seen as detrimental to the company as it guarantees the lender a minimum share irrespective of the future valuation of the company, and may deter future investors. The flip side is that it aligns the interests of the lenders and the entrepreneur in securing a higher valuation for the next round.

Change of Control conversion: If the entrepreneur finds an acquirer for the company before repayment or conversion, the lender may have the right to repayment or to convert the loan amount into shares at a fixed price.

Maturity date: If the loan is not converted within a certain time frame (e.g. 12-18 months), the loan will be repayable (together with interest). Sometimes the lender will also ask for a greater return on his investment (e.g. 1.5x – 3x). Most lenders do not expect to be repaid and this provision is typically used to compel the entrepreneur to secure a qualified financing.

Interest: The loan amount accrues interest, which usually ranges from 5-10% and may convert with the loan amount.

Use of proceeds: The lender will earmark the money for a particular purpose, or tie it to a budget, so that the proceeds are used wisely (and not to line the pockets of the founders).

Security: The lender may ask to secure the loan against the company’s assets so that the debt would take seniority in the event of liquidation.

Investors often prefer this model to a simple equity investment in a start-up, as it secures them better terms. Determining the valuation of a company in an early financing is an art rather than a science. The investor does not want to take the risk of agreeing to a valuation that is too high, and then being diluted in a later down round. They prefer to wait until there is more information available to better value the company. A convertible note does not require a company valuation and by postponing the conversion the investor protects its interest against dilution. Investors also prefer to wait and receive the preferred shares and preferences granted in a future round, than accept ordinary shares now. Finally, as holders of debt the investors will have priority over shareholders in the event that the company goes into liquidation prior to conversion.

Although the threat of repayment may loom over an entrepreneurs head, this model also has certain benefits for startups. Securing money via a convertible note should be a speedier, simpler and cheaper process than an equity investment. The bulk and cost of the more detailed and complex negotiations regarding company valuations and various shareholder rights (such as liquidation and dividend preferences, veto rights, anti-dilution protections etc.), will be postponed and negotiated in the next round. The convertible note is a tool that encourages investors to part with their money now instead of waiting to see who else is going to invest and on what terms, and allows the entrepreneur to spend less time focusing on fundraising and more time concentrating on the company and developing its technology.

As lenders are not shareholders they do not have voting or other shareholder rights. This means that on the one hand the entrepreneur receives the requisite funding and on the other hand he is not diluted and retains control of the company in the interim period. The lenders may ask for various information rights or the right to appoint a director or an observer to the board. However, a director from a reputable VC or angel, may add significant value and gravitas to the young start-up.

Convertible notes are an attractive instrument for investors, they can also be advantageous for entrepreneurs and if drafted correctly should balance the interests of both parties.