Convertible notes are a type of convertible debt instrument commonly used to fund early early and seed stage startups. Startups often choose to raise funding via convertible notes if they are not ready to establish valuation, or expect valuation to change dramatically in the next round, but need or want an influx of cash before the next priced round.
Often, convertible notes will be issued with certain terms, such a valuation cap (often referred to as just a “cap”) or discount, which dictate what will happen when the amount of the loan converts into equity. These pre-defined measures may allow early investors to later purchase shares at a lower price than investors during that round, as an incentive to take a larger risk by investing early-on.
If Peter Thiel had directly invested $500,000 in Facebook’s Series A round, at the $100 million post-money valuation, his investment would have been worth only .5% in Facebook equity.
So – how did Thiel manage to procure 10.2% of Facebook? He likely structured his convertible note with a favorable cap, a term offered to early-stage investors that goes into effect when convertible securities convert into equity. In addition, because convertible notes are debt instruments, they are required to have a fixed interest rate, which can nominally increase the amount at which an initial investment converts into equity.
Valuation Cap (or simply “Cap”): A convertible note cap sets the maximum valuation at which a convertible note investment can convert into equity. Nearly all convertible securities are issued with a cap.
This is significant because the cap sets the value of the investor’s shares. If the valuation ends up being lower than the amount of the cap, the investment made via the convertible note will convert to equity at the amount of the priced round. However, if the valuation is higher than the cap, the investment made via convertible note will convert to the amount specified by the cap. In this latter case, the investor is rewarded for their earlier bet on the startup.
Back to Peter Thiel… In 2004, he invested $500,000 in Facebook’s Seed Round, likely at a $5 million cap, with 2% interest rate. In 2005, Facebook raised a $12.7M Series A at a $100 million valuation (which is way higher than the $5 million valuation cap).
Peter’s investment probably accumulated 2% interest within the year between his Seed investment in 2004, and the Series A Round, in 2005, growing to $510,000.
Since Peter invested via a convertible note with a $5 million cap, his $510,000 investment converted as if Facebook was worth $5 million, rather than $100 million.
Peter effectively invested $510,000 in a $5 million company, giving him a 10.2% equity stake.
Except Facebook was actually valued at $100 million, which meant that Peter’s $500,000 convertible note was worth $10.2 million in just one year.
Discount: A discount on a convertible note states the percentage reduction on round valuation at which the convertible note will convert relative to the next qualified priced round. Effectively this permits an investor to convert the principal amount of their loan (plus any accrued interest) into shares of stock at a discount to the purchase price paid by investors in that round. Discounts range from 0% to as high as 35% with 20% being common.
Basically, a discount on a convertible note is like a coupon starting that early investors can later purchase equity in the startup on sale.
Imagine you invested $250,000 in Instagram’s Seed round via a convertible note with a 20% discount. The seed round established Instagram’s post-money valuation at $2.6 million. Instagram then goes on to close a $7 million Series A round just 11 months later, bumping its valuation tenfold, to a rumored $20 million.
Your investment ($250,000 at a $20 million valuation) would generally convert to a 1.25% equity stake. However, when the 20% discount is applied, your investment converts is if Instagram were worth $16 million (80% of its $20 million Series A valuation), so the note converts to a 1.56% equity stake.
Valuation Cap and Discount: Sometimes, a convertible note will include both a valuation cap and a discount. Typically, the investment will convert at the lower of the two valuations, which favors the investor.
Taking the same example as above...
Imagine you invested $250,000 in Instagram’s Seed round via a convertible note with a 20% discount and a $15 million cap. The Seed Round established Instagram’s post-money valuation at $2.6 million. Instagram then goes on to close a $7 million Series A round just 11 months later, bumping its valuation tenfold, to a rumored $20 million.
In most cases, either the cap or the discount will be applied, depending on which term establishes a lower valuation for the investment to convert at.
If this were true, then the 20% discount would cause the convertible note to convert as if the valuation was $16 million, for a 1.56% equity stake, whereas the cap would cause the convertible note to convert as if the valuation were $15 million for a 1.67% equity stake.
Therefore, since the terms of the cap were more favorable to you, the investor, your convertible note would convert to a 1.66% equity stake, worth $334,000.
The difference is significant, because if the note had converted at a $16 million valuation, to a 1.56% equity stake, your investment would have been worth only $312,000.
Interest Rate: The interest rate on a convertible note indicates how much interest the investment amount will accrue until the note converts to equity. In rare circumstances, interest is repaid in cash. More typically, however, the interest accrued is added to the investment amount, and the initial investment, plus accrued interest, converts into equity.
Securing a high interest rate is not as lucrative for investors as is selecting the right company to fund, and securing a favorable cap/discount rate.
While investors will likely negotiate caps and discounts, interest rate is typically set at 2% on the West Coast (the legal minimum to be considered a debt instrument), and between 4-8% elsewhere in the US. The interest rate on convertible notes typically has no bearing on the ultimate return, as, if the startup is successful, the extra cash generated by the interest rate will seem minimal, at best.
Expiration Date/Maturity Date: The expiration or maturity date specifies the time when the investment converts to equity. Startup investors can sometimes change the maturity date if the parameters upon which the note is set to convert have not yet occurred (think: valuation still isn’t established – no priced round has occurred, or if the startup is between rounds of funding).
It’s very uncommon for investors to “call” a convertible note (force the startup to repay the capital borrowed if the parameters set forth in the convertible note have not yet occurred by the maturity date) as this would generally drain the startup of necessary capital.
It is also considered a self-defeating practice because forcing a cash-strapped startup to hand over what little cash it has all but guarantees its failure, instead of preserving the opportunity to profit on your investment, should the startup prove successful.
Most Favored Nation Clause: A Most Favored Nation clause (MFN clause), is an unusual convertible note term that allows the convertible note holder to elect to inherit any more favorable terms that are offered to subsequent investors following the original investor’s investment, and prior to a next equity round. The MFN clause is sometimes seen on uncapped convertible notes as a way to balance a company’s desire not to cap the note, and an investor’s concern that a capped note may subsequently be issued.
Warrant Coverage: The right for an investor the right to purchase additional shares of stock in a company beyond the converted value of her initial investment. Typically, this is based on some percentage of the principal amount of the loan (plus any accrued interest), and this additional purchase option happens at the point of conversion of the note from debt into equity. The terms vary based on the note. This is a very atypical term in convertible note documents.