On Convertible Notes: The Early Bird Gets the Worm

By Carlos Hernandez Ocampo, Esq.

So, your idea turned out to be pretty awesome. You got a prototype built, and it didn’t blow up, then you sat down for coffee with one of your college professors who told you that you needed $100,000 to start a company and begin manufacturing the widgets en masse. The only question you have now is “Where am I going to get that money?”

Cue in the convertible note music. (I don’t think there is one.) Nevertheless, you googled some things, met an angel investor and now she wants to give you money using something called a convertible note. Let’s go over the basics of what it is.

A convertible note is a short-term loan, it usually states that an investor is lending a certain amount of money to fund your product/service and they decide at a later time if they want their money back with the accrued interest, or if they will rather let the debt “convert” to equity shares in the company. Hence the convertible in the name.

Why Use a Convertible Note?

The preference for convertible notes has been borne out of small startup companies needing the cash to fund a product launch, operations, etc. in a short period of time when conducting an accurate valuation has been impossible or impractical. It has also become the preference of many investors, especially angel investors, when investing in companies that are doing pre-seed or seed rounds of investing, the consensus is that by investing in a debt instrument instead of equity, there may be less risk and a higher chance of getting their money back. This last point is due to the different ways the debt features of a convertible note can be structured, such as the option to secure the note against company assets or that the note has priority over equity should the company fail and have to be liquidated.

Elements of a Convertible Note

There are several terms of art that go into convertible notes that an entrepreneur should be aware of, with four of them permeating most notes. These main four are the discount rate, valuation cap, interest rate, and maturity date.

The Discount Rate is a discount on the valuation of the company that the investor receives when compared to the next round of investors coming in for equity issuances with the next round of financing. Not every note has a discount rate, nor is one necessary. It is considered an incentive that you give early investors for believing in your product and your team and coming in before formal valuation is conducted. This means you can, and should, negotiate the discount rate when in talks with an investor, and while no set number is generally used, the industry trends have fallen anywhere from 5% to 20% at most.

The Valuation Cap is another element commonly seen in convertible notes. Because the company being invested in may not have an actual valuation at the time of the investment, some investors want a valuation cap on the note for when their debt converts to equity. In a nutshell, it means that at the time of conversion the equity will convert as if the company had a set value, the cap, as opposed to the pre-money value of the company when it goes to the next round of financing, which may be higher. This gives the investor the potential to hold more control in the company than the next round of investors. Just as the discount rate, the valuation cap is unnecessary and used as a reward to the first few investors, this means that as an entrepreneur you can negotiate to have one or not have one, and if you do have a valuation cap, you should try for it to be as high as feasibly possible; the trend here is $5 million or more.

Interest Rates are a bit more obvious since the convertible note is in essence a loan. It is the percentage of interest that accrues on the original debt before it turns into equity. There is no set parameter of what the interest rate should be on a convertible note, but the trends in the industry have gravitated between 4% and 8%. There also isn’t a rule that states that it has to be a fixed number, sometimes an investor may want a floating rate such as prime or the applicable federal rate plus 3%. Another thing to consider in negotiations.

Maturity dates are another common term that convertible notes share with other loans. It is the date at which the loan becomes due. This means that the principal amount loaned plus any accrued interest is due to be repaid, or the total amount becomes equity. Another point of negotiation, but the most common terms for convertible notes are 12 to 24 months, even though they are often extended if the company hasn’t hit its mark yet and the investor wants to keep supporting them. The investor can always demand their money back upon the note’s term, but many that invest in early-stage startups will understand that demanding their money back will more likely than not cause the illiquid company bankruptcy or at least to fall on hard times.

How Does This all Work?

Well, you got the basics down, and understand what some of the terms being thrown at you mean, but what does it look like in practice?

Let’s say that your prototype worked, and you start raising capital to fund a manufacturing facility to scale up production. You approached several potential investors and they all want convertible notes, so you hire a lawyer to help you with the negotiations and agree to certain terms for your convertible note. You have a two-year maturity date, with a 5% interest rate. You decided to reward the first believers and you will give them a $5 million valuation cap, and a 10% discount rate.

An investor gives you $100,000 because she believed in your product and your team, what will this loan look like in the future? Twenty months go by and you are ready for the next round of financing, your first round of seed financing with a venture capital firm for example, and the pre-money valuation was assessed to be $20 million at $10/share. Since the terms of the note triggered the conversion from debt to equity when you conducted your first round, that first investor thus has the following:

Original investment of $100,000 x 1.1(discount rate) = $110,000. Her interest of 5% is $5,000 + $110,000 so her total value is now $115,000. However, your company is valued at $20 million, but she had a $5 million valuation cap, so her shares are calculated as $20M ÷ $5M = $4 per share. So, $115,000 ÷ $4 = 28,750 shares in your company. Her initial investment of $100,000 gave her 28,750 shares in your company, while the investors coming into this round will only get 10,000 shares for the same amount of money. That’s a 287.5% return on her investment versus a 5% return had you just paid the loan.

You can see why so many investors prefer using a convertible note with early stage startups -- proving the old saying, “The early bird gets the worm.”