A convertible note is unsecured debt that converts into equity when triggered by a subsequent equity fundraise. In the context of a seed financing, the debt usually converts into shares of preferred stock.
After a triggering event, shares are given a value that is the lower of:
- The price determined by dividing the cap by the number of shares outstanding; or
- The price of the shares issued by the triggering event (or at a discount price, depending on the terms of the convert)
An investor buys a $500,000 convertible note with a cap of $5M, the estimated value of the company at the triggering event is $10M, and there are 7.5M shares outstanding immediately prior to the triggering event.
The shares would convert at the cap rather than the estimated value since the estimated value is higher than the cap. In this case, the conversion price would be calculated as the cap divided by the number of shares outstanding: 66.67 cents/share ($5M/7.5M).
The investor would receive 749,625 shares ($500,000/66.67 cents/share).
An investor buys a $500,000 convertible note with a cap of $5M, the estimated value of the company at the triggering event is $4M, and there are 7.5M shares outstanding immediately prior to the triggering event.
The shares would convert at the estimated value of the company at the triggering event rather than the cap, since the cap is higher than the estimated value. In this case, the conversion price would be calculated as the estimated value divided by the number of shares outstanding: 53.34 cents/share ($4M/7.5M).
The investor would receive 937,383 shares ($500,000/53.34 cents/share).
|Fewer complications: Compared to typically priced rounds, convertible notes are faster, simpler, and cheaper. There is no need to create a second class of shares or issue common stock. |
No pre-money valuation: Convertible notes allow issuers to defer valuation negotiations until a subsequent round of financing. This gives the company time to develop metrics that can be used to determine a fair price.
|Investors can be wary: Some investors prefer to wait until a priced round (even though they will most likely pay a higher price). Early-stage investing is risky, and the investor doesn’t really get paid for the risk if the instrument converts into the next round price.|
Potential stakeholder misalignment: If convertible notes are uncapped, the interests of the issuer and the noteholders are not aligned when it comes to the valuation—issuers want the valuation to be as high as possible, while noteholders want the opposite.
Loss of equity: The founder loses a portion of shares when the note is converted.
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