What’s a convertible note (and why should you care)?
3www.seedchange.com www.earlygrowthfinancialservices.com
• Historically used for bridge rounds
• Now standard for early stage funding (unless you’re in ROW)
• When to use convertible notes: – Seed– Bridge– Supplement
Startup funding cycle
4www.seedchange.com www.earlygrowthfinancialservices.com
Looks like a fish, flies like a bird. . . .
5
• Debt / equity hybrid• Technically debt (interest and terms)• Behaves (mostly) like stock: will convert when
the company does a sizeable equity investment round
www.seedchange.com www.earlygrowthfinancialservices.com
IOU
The FAB of convertible notes—Features
6
• Short agreement• Simple• Flexible• No company valuation• (Largely) standardized terms
www.seedchange.com www.earlygrowthfinancialservices.com
Advantages of convertible notes
7
• Short Quick close(s)• Simple Low legal fees• Flexible Close any time• No valuation No negotiation• Standard terms No negotiation
www.seedchange.com www.earlygrowthfinancialservices.com
Benefits of convertible notes
8
• Short Quick close(s) Save time• Simple Low legal fees Save $• Flexible Close any time JIT funding• No valuation No negotiation Save $/time• Standard terms No negotiation Save $/time
www.seedchange.com www.earlygrowthfinancialservices.com
How it works: a 1-page manual
9
• Decide amount of round and minimum investment• Provide note terms to (accredited) investor• Agree terms• Sign and date
– the note purchase agreement (company and investor) and – the note (company)
• Exchange executed note purchase agreement and note for check/wire
• Add noteholder to cap table (debt page)
Convertible note is classified as debt until it converts to equity
www.seedchange.com www.earlygrowthfinancialservices.com
All the terms that matter
10www.seedchange.com www.earlygrowthfinancialservices.com
• Interest rate
• Note term (Maturity date)
• Discount
• Note cap
Interest rate
11
• All convertible notes include interest rate: IRS says so• Methods for determining the interest rate: – Round number: 5%– Tied to accepted standard: LIBOR
• Interest is paid in shares, not cash• Interest begins to accrue on the date the note is signed• Interest is paid when the note converts to stock
www.seedchange.com www.earlygrowthfinancialservices.com
Use 5%
Term (Maturity date)
12
• Date of conversion/repayment • Typically converts after 12 or 18 months• On maturity• Convert or repay• If neither, talk to your investors about amending
the note purchase agreement
www.seedchange.com www.earlygrowthfinancialservices.com
Use term = 18 months
Discount
13
• Discount on share purchase at time of conversion to stock
• Compensates early investors for greater risk
• 20% is standard• Recent trend in Silicon Valley toward
15%, 10%, 0% discount
www.seedchange.com www.earlygrowthfinancialservices.com
Use 20%
Convertible note cap
14
• Dilution protection, not company valuation• Allows conversion to stock at a ratio
guaranteed not to fall below $_____ • Aligns incentives between investors and
founders• Investor chooses to convert using either note
cap or discount – not both
Median note cap = more or less approx. something like $4.5 million
www.seedchange.com www.earlygrowthfinancialservices.com
Conversion example #1
15www.seedchange.com www.earlygrowthfinancialservices.com
Assumptions:
Note converts after equity investment of $1.5m.
Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.
Assumes no post-money option pool (the last worksheet adds an option pool to this scenario)
Company (pre-funding): DISCOUNT CAP
Shares outstanding* 8,500,000 Series A at conversion Series A at conversion
Effective valuation $3,781,250 Effective valuation $3,925,000
Convertible note terms: Share price $0.44 Share price $0.46
Note Size $575,000 No. of shares 3,371,901 No. of shares 3,248,408
Note Cap $4,500,000 Equity 25.00% Equity 25.00%
Note Discount 20%
Note Holder at conversion Note Holder at conversion
Series A terms: Share price $0.36 Share price $0.46
Series A investment $1,500,000 No. of shares 1,615,702 No. of shares 1,245,223
Series A valuation $4,500,000 Equity 11.98% <----- Equity 9.58%
Return 1.25x Return 1.00x
Note holder converts via DISCOUNT -----> CONCLUSION At this Series A valuation, the note converts
using the DISCOUNT, creating 2.4% more equity for the note holder compared to a CAP. The note holder's return on the Series A is 1.25x.
Cap Table (Ownership) shares %
Team 8,500,000 63.02% *Shares issued to founders and
employees Series A 3,371,901 25.00%
Note holder 1,615,702 11.98%
13,487,603 100.00%
Conversion example #2
16www.seedchange.com www.earlygrowthfinancialservices.com
Assumptions:
Note converts after equity investment of $1.5m.
Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.
Assumes no post-money option pool
Company (pre-funding): DISCOUNT CAP
Shares outstanding* 8,500,000 Series A at conversion Series A at conversion
Effective valuation $12,781,250 Effective valuation $11,775,000
Convertible note terms: Share price $1.50 Share price $1.39
Note Size $575,000 No. of shares 997,555 No. of shares 1,082,803
Note Cap $4,500,000 Equity 10.00% Equity 10.00%
Note Discount 20%
Note Holder at conversion Note Holder at conversion
Series A terms: Share price $1.20 Share price $0.46
Series A investment $1,500,000 No. of shares 477,995 No. of shares 1,245,223
Series A valuation $13,500,000 Equity 4.79% -----> Equity 11.50%
Return 1.25x Return 3.00x
Note holder converts via CAP -----> CONCLUSION At this Series A valuation, the note converts
using the CAP, creating 6.71% more equity for the note holder compared to a DISCOUNT. The note holder's return on the Series A is 3x.
Cap Table (Ownership) shares %
Team 8,500,000 78.50% *Shares issued to founders and
employees Series A 1,082,803 10.00%
Note holder 1,245,223 11.50%
10,828,025 100.00%
The down sides of convertible notes (and an alternative)
17
• It’s still debt—and investors really want equity• Debt incurs interest—and investors really don’t
care• Debt has to be repaid---but what if you can’t?
Why not create something that looks and acts
more like stock?
Someone did: SAFE (Simple Agreement for Future Equity)
www.seedchange.com www.earlygrowthfinancialservices.com
Q&A and Thank You!
Kevin Smith415 Jackson StreetSan Francisco, CA [email protected]@seedchange
Gadiel Moranteswww.earlygrowthfinancialservices.comcontact@earlygrowthfinancialservices.com415.234.3437@EarlyGrowthFS
SEEDCHANGE