Convertible Notes: A Comprehensive Guide for Investors & Startups

A convertible note refers to a short-term debt instrument (security) that can be converted into equity (ownership portion in a company). Convertible notes are often used by seed investorsSeed FinancingSeed financing (also known as seed capital, seed money, or seed funding) is the earliest stage of the capital-raising process of a startup. Seed financing is a type of equity-based financing. In other words, investors commit their capital in exchange for an equity interest in a company. who invest in startups. They are structured as loans to convert it to an equity stake of the company in the future.

As far as the process of funding is concerned, the debt is automatically converted to a known amount of equity shares (common or preferred) at the time of closing the Series A financing roundSeries A FinancingSeries A financing (also known as series A round or series A funding) is one of the stages in the capital-raising process by a startup. Essentially, the series A round is the second stage of startup financing and the first stage of venture capital financing..

To put it simpler, after investors initially loaned capital to a new company (startup) and it’s grown enough to repay the debt, investors wish to get a predetermined amount of preferred stockPreferred SharesPreferred shares (preferred stock, preference shares) are the class of stock ownership in a corporation that has a priority claim on the company’s assets over common stock shares. The shares are more senior than common stock but are more junior relative to debt, such as bonds. instead of receiving their money with interest. It is part of the startup’s original preferred stock financing based on the terms of the convertible note.

Summary

• A convertible note refers to a short-term debt instrument that allows an investor to convert debt to an equity stake in a company.
• Convertible notes are typically issued by newly opened companies (startups) and are frequently used in the seed round of financing.
• Investors use a note’s discount rate, interest rate, valuation cap, and maturity date to evaluate an opportunity of investing in convertible notes.

Main Advantage of Convertible Notes

In essence, issuing convertible notes does not compel the issuer and investors to come up with a value of the company (future company) at the time when they might not be able to properly perform valuation, i.e., when the company is just an idea that needs implementation.

A valuation will be typically conducted during the Series A financing round, given a sufficient amount of data about the company.

Terms of Convertible Notes

When assessing a convertible note to define its value, the following aspects should be taken into account:

1. Discount rate

The discount rate is the valuation rate used to discount future cash flows expected to be derived from an entity in discounted cash flow (DCF) analysisDiscounted Cash Flow DCF FormulaThis article breaks down the DCF formula into simple terms with examples and a video of the calculation. Learn to determine the value of a business. to determine the present value of the cash flows, or, in other words, what is the worth of the valued enterprise today.

2. Valuation cap

The valuation cap represents an additional reward for investors taking a risk by investing at the very beginning stage of a company’s formation. It entitles convertible noteholders to convert to an equity stake in the company at the lower of the valuation price, or valuation cap, in the subsequent financing rounds.

3. Interest rate

Typically, convertible notes accrue an interest rate. The interest accrues to the principal invested, thus increasing the issued number of shares during the conversion.

4. Maturity date

The maturity date is the date when a note becomes invalid because it is due. Thus, the maturity date refers to a date when a company needs to repay the notes, paying off both the principal and interest.

Practical Example

Imagine a company, ABC Ltd., raised funds during the seed round of financing, issuing convertible notes with the valuation cap worth $5,000,000 and no discount prior to the Series A round at a $15 pre-money valuation and $15 share price.

To calculate the valuation cap adjusted share price for convertible noteholders, we need to divide the valuation cap on the note by the pre-money valuation of the consequent financing round and then apply that to the Series A share price. In this case, the adjusted share price of the Series A for convertible noteholders is $3.33.

Provided an individual intends to make a future investment of $100,000. So, $100,000 / $3.33 would give the investor 30,030 shares.

*Please note that a new investor investing the same $100,000 during the Series A financing round would pay $15 per share and, therefore, would only receive 6,666 shares ($100,000 / $15).

More Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Automatic Conversion ClauseAutomatic Conversion ClauseAn automatic conversion clause is a provision that allows for the automatic exchange of preferred stock or convertible debt for common stock in a company. The conversion is considered automatic or mandatory because it does not require a vote of the board of directors for the conversion to take place.
• Convertible BondConvertible BondA convertible bond is a type of debt security that provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond’s lifetime. A convertible bond is a hybrid security
• Pro-Rata RightPro-Rata RightA pro-rata right is a legal term that describes the right, but not the obligation, that can be given to an investor to maintain their initial level of percentage ownership in a company during subsequent rounds of financing.
• 10-Year Treasury Note10-Year US Treasury NoteThe 10-year US Treasury Note is a debt obligation that is issued by the US Treasury Department and comes with a maturity of 10 years.