Primer on Convertible Notes

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Primer on Convertible Notes

  1. 1. (convertible debt, bridge loans)
  2. 2.  It’s debt…  Must be paid back (plus interest) if it doesn’t convert  Goes on balance sheet as a liability It’s equity…  If it converts to equity…it’s no longer debt What’s all this talk about conversion?
  3. 3. If I wait just a few more months, I can get a higher valuation… $2.0 M NeedSelf-fund Cash Series A Bridge Loan (first funding) 6 months
  4. 4. Six months later…Convertible Note Series A • Loan amount: $100,000 • 25% discount $2 M • 8% interest rate • Qualified financing: $1M • Uncapped • 12 month maturityDebt gets converted into an equitystake in the newly valued company
  5. 5. Series A $2 M valuation Amount owedConvertible Note $100,000 + 8% = • Loan amount: $100,000 $108,000 • 25% discount Investor owed $108,000 • 8% interest rate in conversion to equity • Qualified financing: $1M • Uncapped Assume we issued 2,000,000 shares at $1.00/share • 12 month maturity Activate 25% discount$108,000 / $0.75 = 144,000 shares Investor gets $144,000 inof stock = 7.2% ownership equity on $100,000 investment
  6. 6. This gets reallycomplicated very fast…Depends on equity stake taken by Series Ainvestors, warrants, what happens if thecompany gets sold, and other legal stuff…What’s all this talk about caps?
  7. 7. Series A $2 M valuation Amount owedConvertible Note $100,000 + 8% = • Loan amount: $100,000 $108,000 • 25% discount Investor owed $108,000 • 8% interest rate in conversion to equity • Qualified financing: $1M • Capped at $500k Assume we issued 2,000,000 shares at $1.00/share • 12 month maturity But the cap means that we have to treat it like they issued 2,000,000 shares at$108,000 / $0.20 = 540,000 $0.25 each for a $500kshares of stock = 27% valuation cap
  8. 8. Series A $10 M valuation Amount owedConvertible Note $100,000 + 8% = • Loan amount: $100,000 $108,000 • 25% discount Investor owed $108,000 • 8% interest rate in conversion to equity • Qualified financing: $1M • Uncapped Assume we issued 2,000,000 shares at $5.00/share • 12 month maturity$108,000 / $4.00 = 27,000shares of stock = 1.35%
  9. 9. No cap causes misaligned incentives Note investors want a lower Series A pre- money valuation (get more % of company) Founders want a high Series A pre-money valuation (want their stock to be worth a lot)
  10. 10. Advantages Disadvantages• Easier (less paperwork, due • Setting a cap is hard diligence, etc.) • Some Series A investors• Faster hate notes• Lower legal costs • If you don’t have a qualified (debatable) financing by the maturity• Postpones valuation to date, you have debt future round • Potential for misaligned• No board of directors seats, incentives etc. • Convertible notes aren’t• More control over company backed by assets

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