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Convertible Notes: What Founders Need to Know
This document discusses convertible notes, which are a hybrid of debt and equity used for early-stage startup funding. Convertible notes allow startups to receive funding in exchange for a note that can later convert to equity shares. The document outlines key terms of convertible notes like interest rates, maturity dates, discounts, and note caps. It provides examples of how notes would convert under different valuation scenarios. While convertible notes provide flexibility, the document notes that investors ultimately want equity and alternatives like SAFEs were created that act more like stock.
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Convertible Notes: What Founders Need to Know
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- 2. About Your Hosts KevinSmith Founder and CEO Gadiel Morantes Partner SEEDCHANGE
- 3. What’s a convertiblenote (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
- 4. Startup funding cycle 4www.seedchange.comwww.earlygrowthfinancialservices.com
- 5. Looks like afish, 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
- 6. The FAB ofconvertible notes— Features 6 • Short agreement • Simple • Flexible • No company valuation • (Largely) standardized terms www.seedchange.com www.earlygrowthfinancialservices.com
- 7. Advantages of convertiblenotes 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
- 8. Benefits of convertiblenotes 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
- 9. 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
- 10. All the termsthat matter 10www.seedchange.com www.earlygrowthfinancialservices.com • Interest rate • Note term (Maturity date) • Discount • Note cap
- 11. Interest rate 11 • Allconvertible 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%
- 12. 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
- 13. Discount 13 • Discount onshare 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%
- 14. 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
- 15. Conversion example #1 15www.seedchange.comwww.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%
- 16. Conversion example #2 16www.seedchange.comwww.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%
- 17. The down sidesof 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
- 18. Q&A and ThankYou! Kevin Smith 415 Jackson Street San Francisco, CA 94111 www.seedchange.com info@seedchange.com 1.877.711.9883 @seedchange Gadiel Morantes www.earlygrowthfinancialservices.com contact@earlygrowthfinancialservices.com 415.234.3437 @EarlyGrowthFS SEEDCHANGE