Investor Education Series: Convertible Note Conversion Mechanics

Have you ever reviewed a deal on SeedInvest and noticed that the share price is conspicuously missing from the term sheet? The reason for this is that instead of issuing equity (aka a priced round), a company may instead issue convertible notes, a very common form of short-term debt which converts into equity when triggered by a subsequent round of financing. These are not to be confused with SAFEs (Simple Agreement for Future Equity), a security type that is highly scrutinized by our investment committee as the rights and protections provided to investors can vary drastically depending on the specific terms of the SAFE. ^[1]

Convertible notes tend to cause a bit of confusion, even for experienced investors, so we thought it’d be helpful to cover reasons a fundraising company would offer a note, explain the different components of a note, and break down the mechanics of conversion, as there are a few possible methods that can drastically impact noteholders’ ownership post-conversion.

 

Why would a company choose to issue convertible notes in the first place?

There are pros and cons to every security type, but the most often-cited advantages for convertible notes typically include:

• Simplicity: Since convertible notes are technically a form of debt, there is no need to create a new class of securities, avoiding a number of complications that could potentially arise such as stock option grants, related tax implications, shareholder and BOD consent, etc.
• Speed: Closing a convertible note round can theoretically take as little as a handful of days, whereas it can take weeks or months to negotiate all of the terms and documents of a “priced” round (i.e., a round in which the issuer is selling equity directly).
• Cost: The simplicity of convertible note offering documents as well as the speed at which they can be drafted enables companies to spend a fraction on legal fees compared to the documents required for stock offerings.
• Valuation: The valuation of early-stage companies can be difficult to determine. Convertible notes allow issuers to defer valuation negotiations until a future round of financing, at which point they may have developed metrics or established traction which can be used to determine a fair price.

 

So what does a convertible note actually look like?

When evaluating a convertible note, there are a few key parameters to pay attention to:

• Discount Rate represents the valuation discount you receive relative to investors in the subsequent round of financing, compensating you for the additional risk you take by investing earlier.
• Valuation Cap puts a ceiling on the price at which your notes will convert into equity, providing additional protection in case the company raises its next round at a valuation that significantly exceeds the valuation cap.
• Interest Rate provides additional compensation for the time during which your note is outstanding, typically accrued as additional principal (paid-in-kind) that will increase the number of shares issued to you upon conversion.
• Maturity Date is the date that the note is due, at which point the company needs to either have raised a qualified financing, repay the note, or seek noteholder consent to extend the maturity date.

If you’re unfamiliar with how these basic mechanics work in action, we would suggest checking out this blog post first before diving deeper into conversion mechanics below.

 

Conversion Methods

So the company you invested in is now ready to raise their subsequent round of financing, and it is going to be a round. So what happens next? Although SeedInvest engages directly with portfolio company management and counsel to ensure the conversion events take place as stipulated by the legal documents governing your investment, we believe it is important that as an investor, you have a general understanding of how the different potential methods by which a note may be converted. ^[1]

Let’s walk through a hypothetical example that will allow us to compare and contrast the three primary conversion methods: ^[2] 

The company you invested in has $1M of notes outstanding at a $4M valuation cap, a 20% discount rate, and for simplicity’s sake – no interest rate. They have 1.2M shares outstanding (pre-investment) and are now raising their Series A – a priced round – offering $2M of equity at a $12M pre-money valuation. When reading through the different methods, please keep an eye out for how the percent ownership changes depending on which method we use to calculate the conversion.

The Pre-Money Method is the most founder-friendly method, and by far the most common method for conversion. When calculating the conversion, the pre-money valuation is fixed based on what the investors agree to and price per share for the note is calculated based off of it, resulting in all equity holders (both founders and new investors in the priced round) sharing dilution from the conversion of the notes in proportion to their ownership percentage.

 

The Percentage-Ownership Method is the most investor-friendly method. When calculating the conversion, the post-money valuation is calculated by adding the priced round investment to the agreed upon pre-money valuation (exclusive of the notes) which results in a pre-money valuation that is less than what resulted in using the Pre-Money Method above, causing all of the dilution that results from the shares issued upon conversion of the notes to be absorbed by the founders. You can see below that holding all else constant, the founders here would own 64.3% of the company post-investment, versus 70.6% using the Pre-money method above.

 

The Dollars-Invested Method is typically used as a compromise between the Pre-Money Method and the Percentage-Ownership Method with everyone getting diluted a bit. The post-money valuation is calculated by taking the agreed upon pre-money valuation and adding in the priced round investment, plus the principal and interest of the notes that are converting. This results in a pre-money valuation in between that of the Pre-Money Method and the Percentage-Ownership method, which puts the founder’s and investor’s post-investment percentage ownership in the middle of the previous two examples.

 

Below is a comparison of the three different methods in terms of ownership percentage post conversion as well as a breakdown of valuations (pre and post money).

 

In conclusion

The venture capital asset class is nuanced and complex, offering endless learning opportunities to both investors and founders alike. It is important to embrace the fact that even when you do think you are a subject matter expert, there is a good chance that there are certain specifics of an investment you were not even aware existed. Our duty is to help educate investors on what they may not know, but at the end of the day we and our substantial experience in this asset class are here to ensure that both investors and founders are treated fairly and properly. ^[3]

 

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^[1] SeedInvest’s due diligence process is no guarantee of success or future results. All investors should carefully review each investment opportunity and cancel their subscription within the allotted time-frame if they do not feel comfortable making any specific investment based on their own DD. Learn more about due diligence in the SeedInvest Academy (/academy/how-to-assess-a-startup-investment) and our vetting process in our FAQs (/faqs)

^[2] The following examples are hypothetical illustrations of mathematical principles and are not meant to predict or project the performance of an investment or investment strategy.

^[3] This is not meant to be a guarantee of future results, and there can be no assurance that any particular investment strategy will be successful. Nothing contained herein is intended to predict the performance of any investment. In addition, SeedInvest’s diligence criteria does not suggest higher quality investment opportunities nor does it imply that investors will generate positive returns in investment opportunities on SeedInvest.

Note: This post is not a substitute for professional legal advice nor is it a solicitation to offer legal advice.  The foregoing is just a summary of typical terms – legal documents and terms vary widely and the foregoing may not be representative of the terms of any particular convertible note document.  Seek the advice of a licensed attorney in the appropriate jurisdiction before taking any action that may affect your rights.

Source: A majority of the information in this blog post can be attributed to this post written by Derek Colla, partner at Cooley LLP, a silicon valley based law firm.

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