Venture Financing Tips: Convertible Notes

Hear from Jesse Jones, Fourscore Business Law Founder, about Convertible Notes. In this video, he will explain and discuss the value of convertible notes, and how valuation, discount, valuation cap, and interest rate are important topics in the discussion of convertible notes. Stay tuned for the next video in our Venture Financing Tips series and subscribe to our monthly newsletter full of resources here.

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Venture Funding Tips: Convertible Notes

Hi, I'm Jesse Jones, founder of Foursquare Business Law. Thanks for tuning in to this quick video on convertible notes. In this video we're going to cover four things about convertible notes.

One, valuation, discount on conversion, valuation cap, and the interest rate. First of all, valuation. So valuation is one of the major negotiating points in any deal, and one of the major reasons that people use convertible notes instead of preferred stock is that that question of valuation, that negotiation, can be kicked down the road to a later date.

That makes convertible note financings a lot faster and a lot cheaper, which is really, really helpful, especially at an early, early stage. Most often you'll see convertible note deals done as maybe the first money in, the first financing that the company does, or potentially between equity rounds. But it's a great reason to use convertible notes, because you don't have to deal with the valuation question.

Now the discount on conversion. So the way that a convertible note works is the investor puts money in, it's technically debt, and the company issues a note to the investor. However, all the parties understand that the note is really not intended to be repaid.

The intention is for the company to raise more money later, and then take that debt and convert it into equity in the next round. So the discount on conversion is there, and it's typically somewhere between 10 and 30%. Most often I'd probably say about 20%.

And what that means is that when we decide, when the company negotiates with the next investors what the share price is going to be, the note that the investor buys is going to convert into those shares at a discount, at the 20% discount. So if it was, you know, a dollar, it would be roughly 80 cents, would be the conversion price for the notes. That's there really to compensate that early investor for putting their money at risk sooner than the rest of the investors that come in at the later financing.

The valuation cap is a very important piece of a note. From the entrepreneur's standpoint, you want to sort of avoid the valuation cap or push it higher. From the investor's standpoint, they want it to be low, but hopefully everybody's just acting reasonably.

But basically what that says is, yes, investor, note holder, you're going to get a discount on the share price that we sell in the next round. But the investor wants a little bit more comfort that you don't have some rich uncle that doesn't really care what valuation you put on the company, and you go raise $100,000 or $100 million valuation, which would convert their notes into an extremely small percentage of ownership of the company. So the valuation cap says, okay, you're going to get your discount, but in no event are we going to use a value of the company higher than X to convert your notes.

It gives that investor just a little bit more comfort. And then the interest rate is there. It is debt, so it's very normal that there's going to be an interest rate on the convertible notes. However, it's usually relatively low, somewhere between, I don't know, maybe 3% and 8% is probably normal. That's not normally a big negotiating point, but it is part of every deal.

For more information on convertible securities and convertible notes, please check out our venture white paper on fourscorelaw.com. Thanks very much.

Common Questions About Venture Financing Tips: Convertible Notes

• Q: What is a convertible note in startup funding?

  A: A convertible note is a loan to a startup that's intended to convert into equity during a future funding round, not be repaid as cash. Investors put money in early, and that debt automatically becomes ownership shares when the company raises its next round.

• Q: Why do early-stage startups use convertible notes instead of stock?

  A: Convertible notes let startups skip the valuation negotiation, making fundraising faster and cheaper. This is especially helpful for a company's first financing round, since agreeing on a company's value at the earliest stage can be difficult and time-consuming.

• Q: What is a valuation cap on a convertible note in NC startup deals?

  A: A valuation cap sets the maximum company value used to calculate how a note converts into equity. It protects investors from having their ownership stake shrink if the company raises money at a very high valuation in the next round.

• Q: What discount do convertible note investors typically receive?

  A: Convertible note investors typically receive a 10–30% discount on shares when their note converts, with 20% being most common. This rewards early investors for taking on more risk by putting their money in before later investors.