Convertible notes are popular contracts for financing. Using them in combination with Post-money Safes can give more flexibility to the company fundraising. This guide is most relevant for startups fundraising that have just been incorporated to Series A.
Let’s dive a bit deeper into the mechanics of a convertible note using a more detailed example:
- You have a great idea for a new tech startup and you need $100,000 to get it off the ground.
- An investor named John is interested in your idea and offers you a convertible note for $100,000. The convertible note includes the following terms:
- Interest rate: 5% per annum
- Maturity date: 2 years from the date of issuance
- Conversion discount: 20%
- Valuation cap: $2,000,000
- You and John agree to these terms and sign a convertible note agreement. This agreement outlines the terms of the loan and specifies the amount of the loan, the interest rate, the maturity date, and the terms of conversion.
- John gives you the $100,000 as a loan, and you start using the money to get your business up and running.
- Over the next two years, your startup makes great progress, and you are now ready to raise more money. You pitch to a group of investors, and they agree to invest $1,000,000 in exchange for 20% of your company’s equity.
- John now has a choice. He can either:
- Keep his loan as a debt and continue to earn interest until the maturity date, at which point you would repay him the $100,000 plus interest; or
- Convert his loan into equity in your company.
- John decides to convert his loan into equity. Because of the conversion discount of 20%, John gets to convert his $100,000 loan into equity at a 20% discount to the price paid by the new investors. This means that John’s investment is now valued at $800,000 (80% of the $1,000,000 investment).
- However, the valuation cap of $2,000,000 also comes into play. Because the company’s value is below the valuation cap, John’s investment will convert based on the valuation cap rather than the discounted price. This means that John’s investment is converted into equity at a valuation of $2,000,000, even though the company is valued at $1,000,000.
- John now owns a portion of your company worth $100,000, which is equivalent to 5% of the company’s equity ($100,000/$2,000,000).
In summary, a convertible note is a type of investment that starts out as a loan but can convert into equity later on. The investor loans you money at a set interest rate, and the loan can convert into equity based on the terms of the agreement. In this example, John loaned you $100,000 and later converted it into equity at a discount and a valuation cap, giving him a share of your business.