My last post discussed how I think a convertible note is the optimal form for an entrepreneur looking to raise seed stage capital, who anticipates VC money down the line, but who is not quite ready for it yet. This post will explain what a convertible note is, what the terms are that matter, and briefly highlight the (fairly recent) debate over whether a convertible note with a cap is better or worse than a priced equity round.
First: What is a convertible note?
Let’s break the term down into its components.
First, it is a “note” – which means the investor has the option of getting his money back at a specified date in the future with some interest (the specific interest rate is one of the terms that is negotiated).
Second, it is “convertible” – which meansthe investor’s other option is for his money to ‘convert’ into equity in the future (whenever the company raises its Series A or other ‘qualified financing’).
Suppose I invest $100K in your startup via a convertible note. One year later you raise your Series A round of financing from a VC – the VC invests $1.5 million at a $6 million post-money valuation (meaning they get 25% of your company) and the share price goes up from practically nothing to $1 per share. I (the investor) now have a choice – I can either take my $100K back, with whatever interest rate we agreed on, OR I can have your $100K convert into 100,000 shares (since the price is $1 a share). What is especially attractive about choosing the latter option is that I get the same ‘preferred shares’ as the VC with the same terms; in other words, I can rest assured that the VC, with years of experience investing in startups, got good terms for itself, which I now (incidentally) benefit from.
That’s the basic idea of a convertible note, but there are two other terms (besides the interest rate) that need to be negotiated, and which can have a pretty big impact on the deal.
The first term is the “discount rate”. The idea behind the discount rate is that since the first investors in your startup take on the most risk, they should be compensated for this by receiving a ‘discount’ on the share price paid by VCs. In the example above, if I (the investor) negotiate a 20% discount rate as one of the terms in the convertible note you issue to me, this means that instead of having my $100K convert into 100,000 preferred shares (at a price of $1/share), I instead have my money convert into preferred shares at a price of $1 * 20% = $0.80/share, meaning I end up with 125,000 preferred shares.
Some things to note about discount rates:
So far I’ve discussed the interest rate the note bears (typically around 6-8% but this varies), and the discount rate.
The final term to discuss, and probably the most controversial is the “cap”. The cap is easiest to illustrate by example. Suppose in the earlier case (where I invest $100K in your startup), I negotiate a $2 million dollar cap. This means that when you raise your VC round ($1.5 million at a $6 million valuation), my shares convert as if the valuation was $2 million – meaning that I get 5% of the company (i.e. $100,000 shares divided by $2 million), instead of the 1.7% I would have had if there was no cap (i.e. $100,000 divided by $6 million). This is obviously great for me, but not necessarily great for you; hence why entrepreneurs push for as high a cap as possible, or ideally no cap at all. To learn more about the debate over convertible notes with caps, check out this post from David Hornik (a VC who argues that convertible notes with caps are the worst of both worlds when it comes to a debt vs. equity round. Abe Geiger has a good response, and the comments to both blog posts raise a lot of interesting points.