Investment 101: Understanding Convertible Notes
What is a Convertible Note?
Convertible notes are a common investment instrument used to finance early stage companies. The word note denotes a debt instrument while convertible means the instrument can change from debt to equity. The first sources of outside capital beyond friends and family is usually provided by angel investors and early stage investment funds and they will most likely use a convertible note to invest in your company.
Image Credit: Neon Vybes
Convertible notes allow investors to allocate capital with ease and speed. These advantages stem from the convertible note allowing investment to occur without having to determine a company valuation. If you need funding and the investor is keen to fund you, a standardised convertible note contract can be signed and the funds transferred within days. The tricky question about what amount of equity you have potentially sold is pushed into the future and will be determined when a pricing event occurs such as a seed round of funding.
The Two Main Types of Convertible Note
A major improvement to the seed stage investing market was the creation of open source convertible note agreements. Currently there are two popular open source convertible note agreements that are used to make early stage investments. There is the KISS (Keep It Simple Security) which was developed by 500 Startups and the SAFE (Simple Agreement for Future Equity) developed by Y Combinator. Both of these contracts are standardised forms of a convertible note developed by these organisations which have individually both issued 1000’s of notes. Through their experience they have each created a contract (you can find a KISS here and SAFE here) that they feel properly balances the requirements of both the investors and founders. Each has their own points of difference but generally they outline the same basic terms for agreement.
How Convertible Notes Work
In the broadest terms, these convertible notes grant the investor the right to purchase shares of the company when a future equity round occurs. During this future equity round a valuation must be given to the company in order to determine percentage ownership for all parties involved and this includes the previous investors, the ones who purchased the convertible note. The amount invested by the convertible note investor at this point transfers to preferred shareholding based on a calculation via either a valuation cap or a discount method.
These are the key economic terms of negotiation between the investor and the founder when a convertible note is issued. These terms will put the convertible note investor in a more favorable position than that of later investors, which is appropriate as the early investors are assuming more risk. In addition to the economic terms there are additional control terms that also need to be negotiated.
Starting with economic terms, let's begin with discount as it’s simpler to explain. Through negotiation during a seed round the new investors will determine a share price of the company. The convertible note investor will have already negotiated a discount that will apply to that share price. The convertible note investor will have the right to purchase preferred shares at this discounted price.
For example, the convertible note investor funded your start-up with $100,000. You and the convertible note investor negotiated a discount rate of 20%. In the future an equity pricing round occurs and the price per share was determined to be $1.00. The convertible note investor has the right to purchase $100,000 worth of preferred shares priced at $1.00 less the 20% discount which gives $0.80 per share. Therefore the investor will have the right to own $100,000 / $0.80 = 125,000 preferred shares.
Often convertible note agreements will have a discount term and a valuation cap term. The investor will be able to take the most favourable of those terms available to them. Backing up for a moment, the valuation is what both parties agree the company is worth in its totality. The valuation cap term is negotiated to determine the maximum valuation that will be used when determining the conversion price for the convertible note investor’s shares. Let’s say the valuation cap value was negotiated to be $10m.
This value will then be used in the convertible note conversion if the negotiated valuation with the new investors is higher than $10m. If the new investors value the company at $20m, then the convertible note investor will use $10m for their calculation and will essentially receive a 50% discount when converting their note into preferred shares. In this example, if the convertible note investor had a choice between a 20% discount and the $10m valuation cap, they would use the valuation cap to determine their shareholding as it will provide them with the best outcome.
Don’t Forget the Control Terms
Beyond these economic terms, there will be control terms negotiated as well. An important one is Most Favoured Nation (MFN). This term protects the convertible note investor from the company issuing future convertible notes with more favorable conditions. A MFN clause gives the earlier investors the same rights as later investors, if those later investors receive more favourable conditions. For example, in our scenario, if another convertible note is issued with a 30% discount rate, the earlier convertible note investors will also be able to get that discount rate.
In Summary
There are many more terms to negotiate within a convertible note agreement but these cover the basics points of discussion. As always get a second opinion and don’t be afraid to negotiate and push back if you think terms are too onerous. Convertible notes provide an effective way to quickly raise capital by pushing some of the more difficult conversations down the road. However, be prepared as you will still have to have them!
If you’re looking for more guidance on your investment journey? Or need help putting your pitch deck together or forecasting your finances? Send us a message at hello@constellarconsultancy.com and we’d be happy to help!