By: Chujia Yu
March 2018
When entering into seed rounds (preliminary investment stage for startups to establish goals of their business), startups frequently use convertible notes to raise investment capital. A convertible note is a debt instrument that can be converted into equity automatically upon certain conditions and/or at the option of the holder or issuer. Compared to traditional priced equity rounds (an equity-based investment round in which there is a defined pre-money valuation), a convertible note is a simple, cheap, and expedient method for startup funding. Generally, it contains a maturity date provision specifying when the note should be repaid with interest. Standard interest rates vary from 2% to 8%. The maturity date is usually set at twelve to twenty-four months after the first convertible note investment. Usually, when a convertible note has matured, the investor will choose to convert the principal of the note plus the accrued interest into equity. Upon converting, investors choose converting methods between a conversion discount or price cap mechanism.
Why Not Common Stock
People may wonder why the startups do not simply issue common stock to investors instead of a convertible note that will be converted into common shares upon maturity. There are three reasons startups may choose not to issue common stock. First, the issuance of shares of common stock will create a dilution risk for the founders. Since founders and investors often disagree on the value of the startup, it is hard to decide what percentage of ownership interest should be granted to investors. If investors stand a stronger position and are hard to bargain with, founders will risk losing the control of the startup. Second, issuance of stock may trigger negative tax implications. If at the time of corporate formation, the founders issue themselves common stock at par value (which is generally fairly low) and shortly thereafter, issue common stock to investors for the investment (which is generally a large amount of money), the IRS may impute a much higher value on the shares issued to the founders and regard the excess amount over the purchase price taxable to the founders as ordinary income. Third, issuance of common stock will assign value on the shares of common stock. Thus, if a startup has a stock option grant plan in place, the recipient of that option will not be incentivized to stay and help create value for the startup.
Why Convertible Notes
The significant step startups take in fundraising is to go through series rounds (A, B, C, etc.). Series A round is essentially about revenue growth. Generally, a company will be evaluated before each round. However, with the issuance of convertible notes, the valuation process is postponed until the Series A round of financing is closed. In addition, since a convertible note is essentially a loan, it will not trigger the above-mentioned tax problem. What’s more, founders have no need to worry about losing control of the startup. Convertible note holders are rarely granted control rights and have no minority shareholder rights.
The advantages of a convertible note are clear as crystal. However, it is still a bit difficult for people to understand the mechanics of convertible note conversion. There are three key economic terms in a convertible note: (1) the conversion discount; (2) the conversion valuation cap; and (3) the interest rate.
How Convertible Notes Convert
The conversion discount is used to reduce the purchase price per share paid by the Series A investors. It sets a percentage reduction to permit the note holder to convert the principal amount and accrued interest of their loan into shares of stock. The discount ranges from 10% to 35%, with a common discount rate of 20%. Suppose John the Investor invested $1 million into NewCorp, with no interest and a 20% discount for a 1 year term. If during this one-year term, other investors pay $10 for one share and the conversion is triggered, then John only needs to pay $8 for one share, and his total converted shares would be $1 million divided by $8 per share, for a total of 125,000 shares.
While the conversion discount is relatively easy to understand, the conversion valuation cap may be a little more complicated. A conversion valuation cap sets the maximum valuation at which the investment made via the convertible note can be converted into equity. It has the same purpose as the conversion discount, which is to permit the note holder to convert their loan plus interest at a lower price than the purchase price paid by the Series A investors. Using the same example above, suppose the cap was $5 million and the pre-money valuation (valuation of the company prior to an investment) in the Series A round were $10 million. In this case, John can convert the loan at an effective price of $5 per share ($5 million divided by $10 million) and thus receives 200,000 shares. Given the fact that investors receive more shares using valuation cap than a conversion discount, a conversion valuation cap gives the note holder an opportunity to enjoy any increase in the value of the startup prior to the Series A round.
If the qualifying transaction defined in the convertible note is triggered, the conversion will automatically take place. However, in reality, things do not always go so smoothly. More often than not, founders reach the note’s maturity date before they can cause the natural conversion, at which point the founders may want to ask for an extension. The first solution is to increase the interest rate, such as increasing from 7% to 10% to show a nice gesture to the investors. The second solution is to add a valuation cap into the convertible note if originally one was not included. But if the convertible note has a valuation cap in existence, the founders may have to offer a higher discount to make extension possible. To conclude, a convertible note is an effective debt instrument to issue to the investors. What startups need to master are the concepts of conversion discount and valuation cap.