After investing in many convertible notes, and repeating the same conversations about conversion scenarios many times, I’m documenting my thoughts on the topic. Hopefully this is helpful for Founders and angel investors who may be experiencing convertible notes for the first time.
Note #1: This is focused only on conversion scenarios, i.e. how/when the convertible note will convert to equity. There are other important terms to consider in a convertible note financing.
Note #2: This is not an endorsement of convertible notes as a structure. While I generally believe priced equity rounds are better in most situations (a topic for another day), there are situations where a convertible note makes sense.
Note #3: I’m writing this specific to convertible notes, but much of the content is applicable to the SAFE and KISS structures as well.
Scenario #1: company raises qualified future equity round
This is the scenario that Founders and investors plan for and is thus the easiest to address. Qualified simply means the size of the round is significant (typically $1-2 million) such that Founders can’t manufacture an equity financing with non-market terms (e.g. raising $100 from friends/family at $1 billion valuation).
In this scenario, the principle amount invested in the note plus the unpaid interest convert into the same equity being offered to new investors in the qualified equity round (typically preferred shares). Valuation is typically defined as the lesser of the valuation in the equity round * the Discount Rate (or) the Valuation Cap, both of which are key terms of the convertible note.
Scenario #2: company is acquired prior to equity round
This scenario is often overlooked in convertible note financings, but it’s critical to ensure the interests are aligned between Founders and investors.
The best way to address this scenario is to offer investors the choice between:
- converting into Common shares and sharing in exit proceeds pro-rata
- receiving original principle and interest plus a multiple of original principle
The first option is important because investors don’t invest in risky, early-stage companies to earn simple interest. If the company is able to have a large exit without raising a future equity round, convertible note investors deserve to share in this upside just as they would have had the original round been a priced equity round.
Consider this example: company raises $1 million via convertible note with $4 million Valuation Cap and gets acquired for $50 million without raising an equity round. If this scenario is not explicitly defined, investors could get their $1 million principle back + 4-8% interest while Founders keep the rest. Instead, investors should convert into equity at $4 million valuation resulting in 20% ownership ($1 million / post-money valuation of $4 million + $1 million) and thus $10 million of the exit proceeds. This scenario is not very common, but the magnitude of the gap between how investors are treated makes it imperative to address up-front.
The second option is important because average or below-average outcomes could be appealing to the Founder but not to the investor. It’s fair for the investor to have first dibs on exit proceeds before Founders. This mimics liquidation preferences with preferred stock and should be considered by Founders as part of the cost of raising capital from outside investors.
The absolute minimum is for investors to get their original principle back plus interest, but no additional multiple of principle. This is uncommon and generally doesn’t adequately compensate the investor for the risk they’re taking. More common is an additional multiple of original principle of 50-200% with the sweet spot being 100%.
Consider again our previous example where the company raises $1 million via convertible note with a $4 million Valuation Cap, but instead of a $50 million exit, the Founders wish to sell the company for $3 million. Not a great outcome by any measure, but likely to be more attractive to the Founders than the investor. In this scenario, investors get paid their $1 million principle back + 4-8% interest at minimum, plus an additional premium. Using the sweet spot metric of 100%, this would be an additional $1 million.
Scenario 3: company does not raise qualified equity round prior to maturity date
This is the trickiest scenario to address because generally it means the company isn’t doing well and there are no great options. As such, often times convertible note documents don’t explicitly address this scenario, which creates ambiguity and causes problems. I would prefer to avoid this ambiguity by explicitly addressing this scenario.
First, the investor should have the option (but not requirement) to convert into equity. This option protects the investor because without it, the company could simply repay the original principle plus interest to the investor. The conversion should not be automatic as that may not be what the company nor investors desire.
Next, the valuation at which conversion occurs should be pre-determined. This may seem contradictory since often times the main reason for using the convertible note structure in the first place is to avoid negotiation on valuation, but there are best practices here. One option is to use the agreed upon Valuation Cap from the convertible note as the valuation for conversion. This option favors Founders since the Valuation Cap is meant to be the maximum valuation, not a proxy for actual valuation. Another option is to apply the Discount Rate to the Valuation Cap and use the product of the two as the valuation. This is a fairly neutral option and the one I would recommend. Yet another option is for Founders and investors to simply agree on a fixed number up front. (But if you’re able to do this without much effort, you might be better off just doing a priced equity round in the first place!) The last option is to have the company’s Board of Directors determine the valuation at the time of conversion. This can be a good option if the Board composition is neutral, but generally won’t be the case.
Finally, the type of shares investors will receive upon conversion should be pre-determined as well. Options include preferred shares, which favors investors and is more typical, or common shares, which favors Founders. If the company has not previously done an equity financing and doesn’t have preferred shares (as will generally be the case), you can use verbiage like this: “Investors will convert into a newly-created class of preferred shares with terms that are typical of an institutional financing.” This approach will require future negotiation between Founder and investor on specific terms (other than valuation), but captures the intent up front.