Techcrunch has a great three-part blog post series that explores everything you need to know about convertible notes as an entrepreneur. Here they are.
The first article - titled "Everything you ever wanted to know about convertible note seed financing (But are afraid to ask)" introduces the key concepts behind convertible notes. Of note:
- Debt: A convertible note is debt, not equity. It converts to equity on the next priced equity round.
- No valuation yet: Since this is a loan or debt, there is no formal valuation needed to get it done - so it tends to be faster to close than a priced equity round (e.g. a traditional Series A venture investment)
- No control to investors yet: Unlike traditional equity VC rounds, a convertible note does not issue stock yet to investors, so they do not have voting rights. Control of the startup remains with the founders.
The second article - titled "Convertible Note Seed Financings: Econ 101 for Founders" covers the key concepts behind the economics of convertible notes. Of note:
- Discount: The vast majority of convertible notes are set up to convert to preferred stock at the next equity round at a "discount". This rewards early stage investors for taking more risk than the later investors. A typical conversion discount is 20%; that is to say, the seed investors typically can have the money they put in as a convertible note "convert" to equity by paying 80% of the price per stock. If the stock is valued at $1 per stock, then seed investor with a convertible note with 20% discount will have their initial investment convert to equity at $0.8 a share.
- Cap: A valuation cap is the maximum valuation allowed for the startup for the purpose of conversion to preferred stock, regardless of what the valuation of the startup is at the time of the next priced equity round. For instance, the next round could value the company at $10m pre money. If the cap on the note is $5m then the early investors will convert at a lower price per share than if they went all the way to the new valuation of the company. This protects the early investors by making sure they retain a reasonable percentage of ownership even if the startup becomes much more valuable later on.
- Interest: Since this is a loan, there is interest on the loan. A typical interest rate is 7-8% simple interest on the amount owed. The interest is generally not paid out but accrued until the first priced round, at which point the interest is converted to shares just like the principal for the loan.
- Maturity date: This is not mentioned in this article but is mentioned in the next one (see below). Since this is a loan, there is a maturity date typically 12-24 months out.
The third article - titled "Convertible Note Seed Financings: Founders Beware!" covers common pitfalls when entrepreneurs investigate convertible notes. There are two key things to note.
- The scenario in which the startup is acquired before the maturity date of the loan. There are two ways to deal with this - One way is to set it up so the founders give the investors the money back plus interest. The other way is to have the loan convert to equity at a predetermined valuation. The former favors the founders (because it lets the founder retain control) and the latter favors the investor (because it guarantees they get a piece of the action at a price that is early in the game and favorable to the investor). There is a third compromise - read the article for details.
- The scenario in which the loan's maturity date arrives before the first priced round. There are again multiple ways to deal with this. The first way is automatic conversion. The second way is loan extension where founders negotiate with investors to extend the maturity date.