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This article gives a brief explanation on the basics of convertible notes. Valuing an early stage startup is difficult.
Negotiating a valuation with investors is time consuming and often leads to deals falling through. By raising capital through a convertible note, a startup can delay valuing the business until more data is available and the size of the raise warrants a thorough negotiation process. Secondly, convertible notes are usually relatively simple documents. By using market standard documentation, both the startup and its investors can avoid spending large amounts of money on lawyers to draft and negotiate the documentation.
The idea is that, by then, the startup will have some traction and the venture capitalists leading the Series A round will be in a better position to negotiate the valuation. Once the Series A pre-money valuation has been negotiated, the convertible note will convert into equity at a pre-determined discount to the Series A valuation as compensation for the additional risk taken on by the convertible note holders. Convertible notes will typically convert based on either the discount rate or valuation cap — it depends on which of the two gives the investor the higher price.
If your startup is negotiating your first convertible note, try and avoid having a valuation cap.
A valuation cap can act as an anchor on your Series A pre-money valuation. Speak to entrepreneurs and investors with experience in the convertible note space.
LegalVision has raised capital through a revenue loan structure, and Lachlan has invested in a number of startups using convertible notes. SmartCompany is the leading online publication in Australia for free news, information and resources catering to Australia's entrepreneurs, small and medium business owners and business managers. Monday to Friday, SmartCompany. So — how did Thiel manage to procure 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. 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.
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. 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. Basically, a discount on a convertible note is like a coupon starting that early investors can later purchase equity in the startup on sale.
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. 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.
Therefore, since the terms of the cap were more favorable to you, the investor, your convertible note would convert to a 1. Interest Rate: The interest rate on a convertible note indicates how much interest the investment amount will accrue until the note converts to equity.
Company Reliant issues convertible bonds. This amount needs to be calculated as the present value of the non-convertible bond with a three-year maturity which basically corresponds to the shortened time to maturity of the repurchased bonds — Refer next table for calculation. The foregoing is just a summary of typical terms — legal documents and terms vary widely and the foregoing may not be representative of the terms of any particular convertible note document. How the discount rate and valuation cap interact Convertible notes generally convert using the the discount rate OR the valuation cap, whichever gives the investor a better price. In theory, the market price of a convertible debenture should never drop below its intrinsic value. Therefore, since the terms of the cap were more favorable to you, the investor, your convertible note would convert to a 1.
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.
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. 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: