Notes on are convertible notes
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Convertible Notes
A convertible note is a security, typically used by angel investors or seed investors, that is a short-term loan, to provide seed capital for a business.
often preferred by seed investors as a way to fund a new company while avoiding the need to value the company in its earliest stages
should a company fail before the note is converted, the investors interest in the convertible note has priority over an equity interest and is first in line for repayment behind any secured debt (secured against the company’s assets) in the company
Caps and discounts are important because they act as additional rewards for the high risk that investors take in funding new ventures
Valuation caps: they set a maximum price at which the loan will convert from debt to equity.
Consider the following situation: Seed investor’s investment with a valuation cap of $4,000,000 with no discount. Series A company pre-money valuation: $12,000,000. Per-share price paid by Series A investors: $10.00. The valuation cap is adjusted on a per share basis for convertible note holders using a formula like this: $12,000,000 (pre money valuation) / $4,000,000 = $3.00 per share.
A $10,000 investment secured by a convertible note at this point would grant the note holder 3,000 shares at $3 per share, as compared to a Series A round investor, who would pay $10 per share, resulting in only 1,000 shares on a $10,000 investment. Due to the Series A price of $10 per share, the convertible note holder’s $10,000 investment is valued at $30,000
Discounts: they provide a percentage reduction in the cost per share to be paid by the convertible note holder in the relation to later Series A investors. For example, assume that a seed investor is holding a convertible note with a 20% discount rate. Assume also a Series A valuation of $10 per share. Now, consider two investors, the first investing $10,000 secured by a convertible note with a 20% discount rate provision, the second a Series A investor investing $10,000 without a convertible note.
Investor with convertible note: Per-share price applying convertible note discount: $10.00/.20 = $8.00 per share. Therefore, $10,000/$8 = 1,250 shares.
Series A Investor without convertible note:
$10,000/$10 = 1,000 shares
Interest rates: Determines how much interest accrues on the initial loan amount prior to the notes conversion to equity. while a traditional loan requires that interest be paid in cash, a convertible note holder will receive greater equity in the company in the form of additional stock shares up the note’s conversion.
Consider the following situation: Angel investor loans $2,000 to a startup secured by a convertible note with a 5% interest rate. Startup receives Series A investment one year later. Angel investor earns $100 in interest for a total investment value of $2,100. Series A valuation = $10 per share. Upon conversion, the angel investor receives 210 shares ($2,100/$10 per share = 210 shares.)
Maturity date: all these convertible notes have a “due date” which is the date upon which the note is due and payable by the company. at this date, if the company hasn’t raised money from another source, or if it has become profitable and no longer requires additional financing, the note converts to equity shares in the company.
Consider this situation: Angel investor invests $2,000 into a startup. Convertible note has a maturity date of 24 months. The discount rate on the note is 20 percent. The interest rate is set at 5 percent. Shares are valued at $1 after 24 months. Angel investor is entitled to $2,500 worth of shares for an investment of $2,000.
Here's what the formula looks like: $2,000 x 1.2 (discount rate) = $2,400 (after the discount). 5 percent interest for 2 years ($2,000 x 0.05) = $100. Total value to angel investor: $2,400 + 100 = $2,500 in stock.
Advantages of Convertible notes:
dilution: it is often difficult to determine the value of a brand new startup and therefore issuing shares of common stock to raise initial investment funds can result in significant
tax issues: if the company founder or any co-founders accept stock for a small purchase price at the time of incorporation, the investors pay a higher price for their shares at or near the same time, it is possible that the IRS will look at the difference in value as a form of compensation paid to the founders and assign a higher value to the founders’s shares, resulting in those shares being taxed as ordinary income. the use of convertible notes to raise seed funds avoids this potential problem
investor control: one of the pitfalls of issuing stock in return for your company is your loss of company control to the shareholders.
Speed and cost of funding: convertible notes are often far easier to negotiate than other types of financing. online more sophisticated investments that require early valuations and extensive legal involvement, obtaining funding through a convertible note may require only a promissory note and an agreeable investor
When to use Convertible Notes: your concept is ready to go and you need funding immediately, your startup doesn’t have a current valuation and you believe delaying that valuation is beneficial, you’re confident that you will be able to convert the note to equity within the stated time period, the cap and discount of your convertible note are more attractive to angel investments
when to avoid convertible notes: your company already has a fair market value, therefore negating the advantages of convertible notes, you don’t expect to have the required equity available to convert the note by the maturity date, the cap or discount is not attractive enough to secure funds from an angel investor, your prospective investor demands unreasonable concessions in return for funding
FAQs:
Conversion triggers: events set forth in the note that trigger the conversion of the note to equity in the company. the most common is the maturity date. another example is the “next qualified round” meaning that an upcoming round of funding will be sufficient to allow conversion of the note without causing financial harm to the company
Convertible promissory note: the actual document that lays out the terms of the agreement between the investor and founder of the company
Few parameters to be aware of:
Class security: Will the note be converted into ordinary or preferred stock?
Conversion triggers: Convertible notes are meant to be converted in the future, so you must consider the expiration of maturity date at which point the note-holder must convert the outstanding loan amount, ask for the money back, or have the company extend the maturity date.
Note interest: A convertible note is a form of debt, so it accumulates interest over a set time; this interest rate is typically 4 to 8 percent, and it is converted during the next financing round.
Security: Is the convertible note secure and, if so, are the company's assets being used as collateral?
Warrants: This is another form of investment incentive which enables the investor to purchase extra shares.
Valuation cap: This places a maximum price that the loan will convert into equity, which rewards seed investors for the excess risk they're willing to take on.
Discount rate: This calculates how much is owed in compensation for the extra investment risk.
Next equity financing: The next round of financing for the convertible note; in most cases, conversion is automatic.
No next financing: This occurs when conversion is allowed by raising next equity financing fails.
Calculating standard convertible notes typically involves one of three methods: pre-money method, fixed percentage method, dollars invested method.
The pre-money method is set at $8 million and is best for founders because they end up with 60 percent. Founders don't benefit as much from the fixed percentage method, which is also referred to as the post-money method. With the fixed percentage method, founders end up with 55.7 percent. To achieve balance, some investors and business owners opt for the dollars invested method, but it doesn't hold the obvious benefits to either party.
convertible note liquidation preferences are the terms that define in what order shareholders will be paid should their convertible notes be liquidated at a liquidation event. Although all investors would like to have a higher liquidation preference, early investors are generally given liquidation preference over later investors due to their shouldering of greater risk at the outset.
Liquidation preferences. This refers to the contract terms that determine who will get paid what and in what priority in a liquidity event. The two types of liquidation preferences are non-participating and participating.
Non-participating liquidation preference. This type of preference gives liquidation preference to preferred stockholders over common stockholders equal to the price they paid per share or some multiple of the share price. With this, shareholders have the choice to convert their shares into common shares if they want. If they do not convert, then they will be paid the amount of their note plus interest before common shareholders may gain any proceeds from the liquidity event. If they do convert, then they will be paid what was loaned to the business first with interest, then share in any gains made by the liquidity event on a pro rata basis.
Participating liquidation preference. This type of preference is the same as a non-participating preference, except that in this case the holder of the preference, should they convert, will be paid what was loaned to the business first with interest, then a pro rata share of the common stock profits before other distributions are doled out to any remaining shareholders. Normally, there is a 1:1 conversion ratio between preferred and common stock, although this could be higher pending negotiation.
Advantages of Convertible Note Financing for Investors
Get in at the ground floor: Everyone is looking for the next Apple, Microsoft or PayPal and the opportunity to receive stock in the company before it goes public is a tantalizing attraction for many investors. Receiving a convertible note for an investment is putting off the immediate reward of interest for the long-term benefits.
Discount rate: Convertible notes often establish a discount rate that rewards early investors for their faith in the company before Series A investors. A discount rate of 25 percent converts into an equity share of $.075 for a share established at $1 when the Series A round winds up.
Valuation Cap: A valuation cap sets a maximum price above the initial total of the loan and will convert into a larger share of equity of the company.
Conversion Discount: This provision gives investors the right to convert the original amount of their investment, plus an agreed upon rate of interest, into equity and therefore increase the purchasing power of the investor.
Advantages of Convertible Notes for Startups
Valuation is unnecessary. There are no complicated formulas needed to determine the price of the stock. It’s just a matter of waiting until the Series A round has been completed and letting more experienced investors determine the value of the preferred stock.
Control maintained. Notes are converted into preferred shares, not common stock, so the owners of the business do not give up any control in the company.
Efficiency and Cost: Convertible notes require a minor outlay of costs for legal fees and they don’t usually involve a lot of negotiation so they can be turned around in a matter of days.
Sources:
https://www.upcounsel.com/convertible-note-liquidation-preferences