A convertible note refers to a short-term debt instrument (security) that can be converted into equity (ownership portion in a company). Convertible notes are often used by seed investors who invest in startups. They are structured as loans to convert it to an equity stake of the company in the future.
As far as the process of funding is concerned, the debt is automatically converted to a known amount of equity shares (common or preferred) at the time of closing the Series A financing round.
To put it simpler, after investors initially loaned capital to a new company (startup) and it’s grown enough to repay the debt, investors wish to get a predetermined amount of preferred stock instead of receiving their money with interest. It is part of the startup’s original preferred stock financing based on the terms of the convertible note.
A convertible note refers to a short-term debt instrument that allows an investor to convert debt to an equity stake in a company.
Convertible notes are typically issued by newly opened companies (startups) and are frequently used in the seed round of financing.
Investors use a note’s discount rate, interest rate, valuation cap, and maturity date to evaluate an opportunity of investing in convertible notes.
Main Advantage of Convertible Notes
In essence, issuing convertible notes does not compel the issuer and investors to come up with a value of the company (future company) at the time when they might not be able to properly perform valuation, i.e., when the company is just an idea that needs implementation.
A valuation will be typically conducted during the Series A financing round, given a sufficient amount of data about the company.
Terms of Convertible Notes
When assessing a convertible note to define its value, the following aspects should be taken into account:
1. Discount rate
The discount rate is the valuation rate used to discount future cash flows expected to be derived from an entity in discounted cash flow (DCF) analysis to determine the present value of the cash flows, or, in other words, what is the worth of the valued enterprise today.
2. Valuation cap
The valuation cap represents an additional reward for investors taking a risk by investing at the very beginning stage of a company’s formation. It entitles convertible noteholders to convert to an equity stake in the company at the lower of the valuation price, or valuation cap, in the subsequent financing rounds.
3. Interest rate
Typically, convertible notes accrue an interest rate. The interest accrues to the principal invested, thus increasing the issued number of shares during the conversion.
4. Maturity date
The maturity date is the date when a note becomes invalid because it is due. Thus, the maturity date refers to a date when a company needs to repay the notes, paying off both the principal and interest.
Imagine a company, ABC Ltd., raised funds during the seed round of financing, issuing convertible notes with the valuation cap worth $5,000,000 and no discount prior to the Series A round at a $15 pre-money valuation and $15 share price.
To calculate the valuation cap adjusted share price for convertible noteholders, we need to divide the valuation cap on the note by the pre-money valuation of the consequent financing round and then apply that to the Series A share price. In this case, the adjusted share price of the Series A for convertible noteholders is $3.33.
Provided an individual intends to make a future investment of $100,000. So, $100,000 / $3.33 would give the investor 30,030 shares.
*Please note that a new investor investing the same $100,000 during the Series A financing round would pay $15 per share and, therefore, would only receive 6,666 shares ($100,000 / $15).