The Mechanics of Convertible Notes

This article is a follow-up to Early-Stage Financing and Convertible Notes. It will provide a broader understanding of the convertible note structure and the mechanics of convertible notes.

There are several important reasons for entrepreneurs to seriously consider convertible notes for early-stage financing. First, the overall speed from term sheet to issuance for a convertible note is generally faster than a typical common or preferred stock transaction [1]. A market standard convertible note offering can be pulled together within three days if both the issuer and investor are motivated. The term sheet will be two to three pages as opposed to eight to ten pages for a Series A offering. The final offering documents tend to be concise and understandable to laypeople. All of the above significantly lowers the overall legal expenses for a startup company.

Second, the battle over valuation can be avoided until a later date when there are more data points upon which to anchor a valuation. Theoretically, the valuation will be greater the further in time one gets from a company’s founding. For the entrepreneur, this means selling a smaller slice of his or her company, which ultimately means giving up less control to investors at an early, uncertain stage.

Finally, the ease with which an early-stage company can raise seed capital from multiple investors over the course of multiple closings makes convertible note offerings attractive. Gathering investors for a single closing for the full amount of a particular round is often daunting and difficult to execute. Convertible note offerings, however, allow the company to have multiple closings with different investors in the same round consisting of substantially similar deal terms and documents. This flexibility is a huge benefit to entrepreneurs as their companies evolve.

A convertible note is a relatively straightforward debt security instrument. In the context of seed financing, the company issues a promissory note (i.e., a promise to repay) to the convertible note investor. In exchange for the promissory note, the note investor transfers the face value of the promissory note (i.e., the investment amount) to the company. The conversion feature means the company is not obligated to repay the face value of the promissory note or any accrued interest to the convertible note investor in cash. Instead, the entire debt (principal plus accrued interest) is repaid in preferred shares (or common shares) upon the occurrence of a qualified financing. At that time, the convertible note and related payment obligations will cease to exist. The qualified financing is usually the closing of a Series A financing. The implicit assumption is that the professional investors will be better positioned at the time of the qualified financing to place a valuation on the startup company.

Interest Rate — There is generally very little contention over the interest rate in convertible note offerings. Quibbling over interest is pointless given that the real upside for a convertible note investor lies in the conversion of the convertible note into equity. Interest rates between six percent and ten percent would be considered standard and would not raise any eyebrows among institutional investors when the time comes for a Series A financing.

The Discount — The basic idea behind the convertible note discount is that note investors ought to receive compensation beyond just the interest rate to account for the greater risk that they take by investing at the most uncertain stage in the company’s lifecycle. The discount allows convertible note investors to purchase the securities offered in a qualified financing at a discounted price to per share versus the amount paid by the qualified financing investors. For example, assuming a twenty percent (20%) discount, if the shares at the qualified financing are being purchased for $1.00 per share, the convertible note investors would pay $0.80 per share for the same securities. The range of discounts typically seen is between ten percent (10%) and thirty percent (30%).

Valuation Caps — The valuation cap protects the convertible note investors by placing an upper limit on the price per share at which the convertible note will convert into equity. This permits the convertible note investors to share in any sharp increase in the company’s valuation between the time of their investment and the qualified financing. Though the valuation cap takes valuation into consideration, it still permits the entrepreneur and convertible note investor to defer placing a definitive value on the company. However, it does permit the convertible note investor to guarantee that his or her investment, when converted, will purchase a sufficient equity position in the company to account for the risk taken at the seed stage. See the scenarios below to get a better understanding of valuation caps:

Hypothetical Convertible Note Language: The conversion discount shall be the lower of (a) a 25% discount to the Series A share price, or (b) the price per share if the Series A pre-money valuation was set at $7,500,000.

Scenario #1: Uncapped Convertible Note With A 25% Discount
Pre-Money Valuation: $5,000,000
Series A Financing: $2,000,000
Post-Money Valuation: $7,000,000
Note Investment: $100,000
Note Investor Stake: 1.9%

Scenario #2: Uncapped Convertible Note With A 25% Discount
Pre-Money Valuation: $15,000,000
Series A Financing: $2,000,000
Post-Money Valuation: $17,000,000
Note Investment: $100,000
Note Investor Stake: 0.78%

Scenario #3: Capped Convertible Note At $7,500,000 With A 25% Discount
Pre-Money Valuation: $15,000,000
Series A Financing: $2,000,000
Post-Money Valuation without Cap: $17,000,000
Valuation Cap: $7,500,000
Post-Money Valuation with Cap: $9,500,000
Note Investment: $100,000
Note Investor Stake: 1.05%

Valuation caps can affect valuation in a qualified financing. A Series A investor may use the valuation cap to insert an artificial ceiling on the value of the company in successive rounds of financing.

Hopefully you found the above explanation to be both informative and helpful in the decision-making process of how best to raise early-stage capital for your company. The goal here is not to cover the minutia of convertible note financing, but instead to give entrepreneurs the basic tools to intelligently discuss and select the best financing option for their individual situation. If we can assist you in navigating the world of early-stage financing, please feel free to contact Michael G. Salmon, a partner at SalmonLaw, by clicking here.

[1] This is true even when one takes into account the multitude of document standardization initiatives for equity issuances in existence.