Continuing on from my first article on what is Common Stock, we now move on to understanding what are Convertible Notes, in our quest towards understanding the lingo you will need when dealing with Venture Capitalists.
What is a convertible note?
As a founder in the early stages of your startup looking to get some cash to build your infrastructure, you would take out what is called a convertible note, a loan that eventuates into equity when your company has a bit more operating history and you can substantiate a fair price down the line.
This debt instrument is essentially unsecured, and allow you to defer defer having to unfairly decide how much your company is worth during seed rounds, because you may still be composing your team amongst other things, which would certainly increase your company value if you somehow hire superstars.
You usually raise between $100 and $2 million dollars.
How does a convertible note work?
Convertible Notes usually come with a maturity date, where the note as well as interest rate (usually between 1-to-3 years) needs to get paid back. You get the money usually immediately but you have to defer the number of shares you as the founders distribute amongst yourselves until the next round of financing, when a more accurate evaluation of your company can be ascertained.
At that stage, the loan you have converts into shares along with a conversion discount which rewards your investors for the additional risk they took to invest early, prior to the pricing of your company.
The convertible note valuation cap is another form of rewarding the investors that take an early-risk on your venture, by setting the maximum price your loan will convert to into equity (in case your price evaluation somehow explodes next round of funding).
To translate that into a share price, you divide the valuation cap by the series A valuation. Lets say you invest in a startup using a note with a $3 million cap. If the series A investors decide that the company is worth $6 million dollars and pay $1/share, your note will convert into equity AS IF the price had actually been $3 million. By dividing $6 million by $3 million we get an effective price $.50/share. That means that you will get twice as many shares as the series A investors for the same price. (source: WeFunder)
The good and the bad
For investors, they provide great downside protection whilst deferring pricing of your company until you have enough time to substantiate your ideal company evaluation, making it an attraction proposition for investors especially when you don't have the 'street-cred' in Silicon Valley. The cons include the potential to dilute your stock pricing due to having a valuation cap that is too low (too high a discount).