So, we all know that financial capital and cash flow is the life-blood of any company. Nowhere is this truer than in the startup world. Generally, startups will seek seed (early-stage) financing in order to get the initial capital injection it needs to begin its operations and/or bring its product to market.
At this early stage, startups have two options: debt financing or equity financing.
Debt financing means borrowing money that has to be paid back. With debt financing no ownership is relinquished. For startups, debt financing typically looks like a traditional loan.
Equity financing is receiving money in exchange for giving up some ownership. Equity financing for startups usually involves family and friends (or angel investors) giving an agreed upon amount of money for an agreed upon amount of ownership, which is usually decided upon using an arbitrary calculation.
In between these two options, there lies a hybrid investment tool that has been used by many startups and encouraged by many investors. This is the convertible note.
A convertible note is a debt instrument that converts into equity upon the occurrence of some triggering event, typically at the closing of a Series A round of financing. When the later round of financing closes, the startup receives an actual valuation. The principal amount of the convertible note, along with any accrued interest, is paid off by issuing preferred shares of stock to the note holder.
To enter into this deal, a promissory note is signed by the startup. This promissory note details the amount of money loaned, the interest rate of that loan, and the date on which the loan matures. Although a convertible note is a debt instrument with a set maturity date, investors rarely call-in the loan, as it would defeat the overall purpose of the instrument.
At this time, there is also a conversion agreement that is entered into. This conversion agreement highlights the triggering event upon which the note will convert into equity. It also outlines the terms of the conversion. Two main terms that will be negotiated are the discount rate and the valuation cap.
The discount rate sets a reduced price at which the note holder can purchase the shares. For example, let’s say the note is for $100,000, the discount rate is set at 20%, and the price per share is set at $5. The note holder will be able to purchase shares at a price of $4 per share [5x(1-0.2)], giving the note holder 25,000 shares.
The valuation cap sets a max limit at which the convertible note can be assessed in the conversion. For this example, let’s again say that the note is $100,000 and let’s say that the valuation cap is set at $5 million. Let’s also say that the Series A financing sets the startup’s valuation at $10 million, again with a price of $5 per share. The note holder, in this situation, will be able to purchase shares at $2.50 per share. To get this number you would take the $5 million cap and divide it by the $10 million valuation. You would then take that number and multiple it by the price per share (i.e. 5/10= 0.5; 5×0.5= 2.5). This would give the note holder 40,000 shares.
If a conversion agreement contains both a discount and a valuation cap, the note holder will receive the better of the two deals upon the conversion; in the above situation it would be the valuation cap.
These are the high level basics of a convertible note. In Part II, we will discuss some of the benefits of using a convertible note.
Jamal Jackson, JD/MBA is a corporate attorney licensed in the State of Illinois. He is the CEO and Managing Attorney of Jackson Corporate Law Offices (www.JacksonCounsel.com), Co-Founder of Initiative Consulting Group, LLC (www.initiativecg.com) and a Public/Motivational Speaker engaging audiences in the topic areas of Business, Leadership, and Legacy (www.JamalEJackson.com).