Primer on Convertible Notes

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  • 1. (convertible debt, bridge loans)
  • 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. 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. 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. 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. 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. 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. 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. 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. 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