Convertible Note

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What is a Convertible Promissory Note?

A convertible promissory note is a type of hybrid financing that begins as short-term debt that is converted into shares of stock, or ‘equity’, at a later date.

Essentially, an investor makes a loan to a business in exchange for the promise of converting the value of that loan into shares of stock at a discounted rate once the business takes off.


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Who Uses a Convertible Promissory Note?

A convertible promissory note is most often used by new companies to raise capital before the true value of the business is known.

When a new business is first being formed, it often needs to raise funds from investors who are willing to take a bigger risk on an untested company in exchange for higher reward potential. Convertible notes allow these investors to share in the success of a new business because the shares of stock they receive later will be worth more than the amount of the original loan.

Key Terms

  • Note Value: The amount of the original loan.
  • Discount Rate: A specified ‘bonus’ amount that the investor will receive in shares when the note converts. The most common discount rate is 20%, but typically is 10% – 35%.
  • Valuation Cap: An upper limit on the value of the business, above which the investor will receive a greater proportion of the company’s stock. Valuation caps are used to ensure that investors fully share in the success of a business that does very well as a reward for investing early, when risk is highest.
  • Seed Round: The initial round of fundraising during which convertible notes are most likely to be issued.
  • Series A Round: The second round of fundraising. At the conclusion of Series A, convertible notes issued during the seed round are automatically converted to shares.

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Other Things to Consider

While the above terms are the most important to understanding convertible notes, there are two other components that can also play a role.

Though the true value of a convertible note is mostly dependent on:

  • The value of the company after Series A fundraising
  • The discount rate
  • The valuation cap

Two other factors can come into play – especially if the company is not able to complete Series A financing in a timely manner.

Interest Rate

Because a convertible note is technically a loan, notes carry a simple interest rate, generally between 5-10%, annually. Interest is not paid out monthly, but rather accrues over time and increases the total convertible note value.

Maturity Date

Convertible notes do carry a maturity date which is typically 12-24 months after issuance. Like bonds, if a note is not converted prior to maturity, then the business must pay back the loan amount and any interest accrued unless the note stipulates other options. However, most new companies that do well complete their Series A round of financing long before note maturity, at which point the notes are converted to shares.

Example

During the seed round of fundraising for a new venture, assume you invest in a convertible note with the following terms:

Investment Value: $500,000

Interest Rate: 7% Annually

Discount Rate: 20%

Valuation Cap: $5 million

Maturity Date: 24 months

The company completes its Series A round of financing exactly six months after the issuance of your note and is now valued at $10 million.

Interest Accrued in 6 Months = $500,000 * 7% / 2 = $17,500

Total Note Value = $517,500


Since Series A is complete, your note will convert long before maturity.
If the company’s stock is now valued at $50 per share, the number of shares your note will convert to based on your 20% discount rate is:

$517,500 / ($50 * 80%) =

$517,500 / $40 = 12,937 Shares

Market Value of Shares = 12,937 * $50 = $646,850

However, because the valuation of the company exceeded the $5 million cap, you are eligible to receive a greater portion of the company’s stock.

The valuation cap conversion rate is determined by dividing the cap by the company’s true value:

Valuation Cap Conversion Rate = $5 million / $10 million = 50%

Conversion Rate

Using this higher discount conversion rate, the number of shares you are entitled to is:

$517,500 / ($50 * 50%) =

$517,500 / $25 = 20,700 Shares

Market Value of Shares = 20,700 * $50 = $1,035,000


Because of the company’s success, early investors are rewarded for their higher-risk investment. In this case, the valuation cap provision means your investment is worth 60% more than it would have been had the company’s valuation remained below $5 million.

Converted Note Value Difference Due to Valuation Cap =

($1,035,000 – $646,850) / $646,850 * 100 = 60%

Fun Facts

  • Investors that purchase convertible notes or otherwise participate in the seed round of fundraising are typically called ‘Angel Investors’ because they take on huge risk to help new businesses get off the ground.

References

  1. http://lexicon.ft.com/Term?term=convertible-note
  2. http://martin.kleppmann.com/2010/05/05/valuation-caps-on-convertible-notes-explained-with-graphs.html
  3. https://fundersclub.com/learn/convertible-notes/convertible-notes-overview/what-is-convertible-note/
  4. http://www.siliconlegal.com/reports/seed-financing-report-2015http://seedcamp.com/resources/the-essentials-of-convertible-notes/
  5. https:// techcrunch.com/2012/05/13/convertible-note-seed-financings-part-3/
  6. https:// techcrunch.com/2012/04/07/convertible-note-seed-financings/https://
  7. techcrunch.com/2012/04/21/convertible-note-seed-financings-econ-101/

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