Startup funding: Convertible notes primer

I’ve been working in the early-stage (pre-Series A) startup world for over two years now, and have been part of many discussions about how to fund companies at that stage. The most common funding source at this stage tends to be the general “friends and family” pool, and the most common mechanism for actually raising those funds tends to be convertible notes (often abbreviated as “converts”).

There are other options – this post talks argues for raising early-stage through straight equity rather than converts and even provides the framework legal docs to get started. I will discuss my experiences with converts and my thoughts on raising via converts vs. equity in a different post. In this post, I aim to provide a simple primer on how converts work and what the key terms are. The real reason for this post is because while at Winestyr, I’ve had to explain converts to a number of people that I’ve hired…and it can get complicated. Techcrunch also has a great guide to converts, but I think it’s a bit involved for someone just getting started. To keep things simple, I’ll also avoid discussing tax implications of converts vs. equity financing – if you want more details on that, the Techcrunch piece has some good starting info.

Converts exist for one main reason: they save both the founders and the investors time by allowing them to defer important decisions about the company until a later date. The key question they defer is valuation – if an investor wants to invest $100,000 in a company, what % of the company should that investor receive for that $100,000? For publicly traded companies, this is never a question – if you buy $100,000 of Facebook stock, for example, that means you now own roughly 0.0001% of the company – because investors have determined that Facebook overall is worth about $100 billion. As an investor, you know this when you purchase the stock because all of that information is publicly available and governed by Facebook’s trading activity on the public stock market.

However, private companies like startups do not trade on any sort of public market, so there is no outside source to consult when you want to know how much of the company your $100,000 will give you. In a world without converts, you’d have to come to an agreement with the founders about what the company was worth, and then document that agreement as part of your investment. For example, you and founders could agree that the company was $900,000 without the $100,000 investment, meaning that after the investment it would be worth $1,000,000 and you’d own 10%. However, coming to an agreement on the value of a company that is unlikely to have much in the way of revenue and certainly won’t have years or even months of operating results is a hard process! The founders of the company will want that valuation to be as high as possible to they give up less of the company to you the investor, and vice versa. Converts allow you to defer this difficult (and time-consuming) discussion.

The way converts accomplish this is by making the assumption that the company will raise additional funding in the future from more experienced investors than the initial friends and family group. This could be from venture capitalists or from sophisticated private investors often called “angels”. The assumption is that these sophisticated investors will have an easier time establishing a value for the company, partially due to their experience but also just because the company will have more data with regard to how it is performing that will help arrive at a value.

Mechanically, the way this works is that the convertible note simply converts into equity at whatever valuation that later round of sophisticated-investor financing sets. For example, if a company raises $500,000 from friends and family in the form of a convert, and then one year later raises money from VC at a $3,000,000 valuation, the convertible note would convert into an ownership percentage equal to $500,000 / $3,000,000 or 16.67% of the company.

There are of course many complicating terms and factors involved with converts. The three main ones are interest, triggers, and caps/discounts. One big reason for these terms is to provide the convert investor with some extra value for putting money into the company at a riskier time than the subsequent sophisticated investor – it just wouldn’t be fair to that earlier investor to give them the same terms as the later investment.

  1. Interest – most convertible notes have an interest rate attached to them (usually in the 8% per year range). This gives the investor some additional value when their note converts into equity. In the example above, if the $500,000 convert had an interest rate of 8%, after one year when the company raised VC money, the convert would have a total value of $540,000 instead of the $500,000 that was actually invested. This would in turn mean that the convertible note would actually be worth 18% of the company instead of the 16.67% above ($540,000 / $3,000,000 instead of $500,000 / $3,000,000). Interest rates are very standard in converts and rarely a source of significant contention during negotiations.
  2. Trigger – Convertible notes have to define some “trigger” event – that is, what actually causes you to undergo the conversion? This is usually either a funding amount, for example, the “first additional financing of at least $1,000,000.”  It could also be a valuation threshold, such as “the first additional round at a valuation of $2,000,000 or above” or just something as simple as “the first additional round of financing that sets a valuation.”
  3. Cap/discount – One outcome a convert investor might be worried about is since they put money in without establishing what that investment is worth, what happens if the company really blows up so that when they raise their next round, the valuation is very high? Caps/discounts solve for this issue. A cap is the maximum reference valuation when calculating how much equity the note converts into – in the example above, if the note had a $2,000,000 cap, then even though the company raised money at a $3,000,000 valuation the convert holder would actually own 25% of the company post conversion ($500,000 investment / $2,000,000 cap).  A discount is similar in concept – it gives the convert investor a discount to the valuation of the equity round when calculating the post-conversion ownership.  Sticking with the example above, if there was a 25% discount with the note, the note would convert using a reference price of 0.75 * $3,000,000, or $2,250,000, yielding an ownership percentage of $500,000 / $2,250,000 = 22.2%. These terms are often used together, and are more complicated to negotiate and resolve than either the trigger event or interest rate. There is no wide consensus on what is “standard” or “market”, but from my experience and reading, I’d say a discount of 15-30% and a cap in the $5-7 million range seems reasonable.

Hopefully this post helps provide some background on what converts are and how they work. If you have any questions or think something is unclear, let me know in the comments and I’ll do my best to rectify.

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