How Do Convertible Notes Work For Early-stage Financing
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What is the definition of convertible debt and how to use it in early-stage startup financing. You can also see the calculations we made using our Convertible Note Calculator.
To read more take a look at this article: https://www.equidam.com/practical-advice-pricing-convertible-note/
Compute your company valuation for free at https://www.equidam.com/
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How Do Convertible Notes Work For Early-stage Financing
2. What are convertible notes?
A convertible note is:
A financial instrument used for investments in early stage companies
A short-term debt that converts into equity at a trigger eventA 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
3. 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
4. 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
5. 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
6. 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
7. 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
8. 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
9. 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.
10. How will it affect your cap table?
Convertible note
Cap = $4M
Discount = 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
11. 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%
12. 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
13. 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]