You’ve got an idea, you’re starting a company and like most people with an idea, you need some money to help get it started. You’ve already looked through the couch cushions, begged your parents for whatever they can spare, and the plasma center said your counts aren’t high enough for them, so now what? “Shark Tank?” Your company isn’t quite ready for prime time. Your fledgling company has great prospects, but you’re short capital; perhaps a convertible note is the solution!
In easy terms, a convertible note is basically what it sounds like, a loan that will convert to equity. It is a short-term loan investors hand out without having to put a value on your brand new company. This note won’t convert into equity until a later round of funding.
To better understand, let’s look at an example:
Suppose you want to start a Premium Dog Walking Company and you need money. You are issued a $10,000 convertible by your mother-in-law. Pretty soon you are waking every dog (even the small ones that really don’t need walks) in the East Coast! Wahoo, you’re ready to expand to the West Coast, and you need more money. You raise a series A round at a $10 million pre-money valuation. How much equity does your mother-in-law now have with her original $10,000 convertible note investment?
% of Company for Convertible Note Holders = Convertible note price / Valuation of company
= 10,000/10,000,000 = 0.1%
Lucky you, your mother-in-law only own 0.1 percent of your company! Sounds too good to be true right?
Not quite …. a convertible note has a few strings attached that make it a little more complicated. Things called “valuation caps,” and “discount rates,” are often attached to convertible notes and keep things interesting.
A valuation cap is the maximum value your company will be valued at when the note converts to equity. To figure this out, let’s look back at our Premium Dog Walking company. This time your mother-in-law is a bit smarter, and issues you a convertible note of $10,000 with a valuation cap of $1,000,000. You go on to raise the same series A at a $10 million pre-money valuation. How does this change your mother-in-law’s investment? Well, since she had a $1 million valuation cap and believed in your Premium Dog Walking Company before you had even walked a single dog, she got a bit of a deal on her investment.
With the convertible note having a valuation cap, your mother in law now owns 1.0 percent of your company instead of just 0.1 percent. Dang.
What about a discount rate? A discount rate is exactly what it sounds like, the convertible note holders will get a discount on the valuation decided in the next funding round.
Let’s go back to your Premium Dog Walking Company to illustrate the point. This time, you received a $10,000 convertible note from your mother-in-law, same as before, but the convertible note has a 20 percent discount rate attached to it. You again are doing well and raise the same a series A round of funding at a $10 million pre-money valuation. What percentage of your company does your mother-in-law now own?
With this combination of convertible note and a 20 percent discount rate, your mother in law now owns 0.5 percent of your company.
Many times, a convertible note will have both a valuation cap and a discount rate. This guarantees the best price for the convertible note investors. I know, pretty sneaky, but would you expect anything less from your mother-in-law?
If your mother-in-law offers a convertible note with BOTH a valuation cap of $1 million cap AND a 20 percent discount rate, she would end up with 1.0 percent equity, because the valuation cap would win out over the discount rate.
Why do convertible notes exist and why do investors get such a steep discount? Many times, investments made with convertible notes are in companies which are as early as just an idea. The chance of this company growing and becoming something valuable is pretty small, which means this risky investment needs to be justified. Sounds pretty simple right? It is! Convertible note contracts are often only a few pages long, and rather simple to understand, so simple even your mother-in-law can understand them.