Conversion scenarios for your Convertible Note docs

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.


What I’ve learned in 3 Years of Angel Investing

This post isn’t meant to be an all-encompassing guide to angel investing. That topic has been written about extensively by people with more experience than me.

Rather, the goal of this post is to share a few (hopefully non-trivial) things I’ve learned in my first few years of angel investing. The target audience is anyone interested in angel investing but not quite sure how to start.

I’ve organized the post into 2 sections: 1) the top 4 things I’ve learned, and 2) actionable steps for those looking to get started.

The top 4 things I’ve learned

  1. Understand the basic math
  2. Have a basic strategy
  3. Getting started is more important than being an expert
  4. Following others is a good beginners strategy

Understand the basic math

~70% of angel investments fail, ~25% produce some return, and ~5% produce a big return (usually described as >10X). I’m using the ~ qualifier here because different studies have slightly different numbers, but consider this math directionally accurate.

This basic math has profound implications. It means most of your angel investments will fail, and this should not surprise/frustrate/upset you. It means some of your angel investments will produce some financial return (but not a big win). And most importantly, it means the overwhelming majority of your financial return will come from just 1 in 20 investments. This basic math leads to two key conclusions: 1) having home runs is critical to financial success, and 2) you will most likely need to make a lot of investments to find a home run.

Let’s validate each conclusion.

Why is finding a home run critical to success?

Apply this basic math to a theoretical portfolio of 20 investments. For simplicity sake, let’s assume you invested 1 unit total in each company (more on follow-on investing later):

14 companies fail (0 units returned)
5 companies produce some return, let’s say an average of 2X your investment (10 units returned)
1 company is a home run returning 15X your investment (15 units returned)

The result is a return of 25 units on 20 units invested. Not great, but profitable. However, without the big win, the result is 10 units returned for a loss of 50%. To be successful at angel investing, you need home runs.

How many investments are needed to find a home run?

Let’s apply some probability to our math above.

p = 0.05, probability of a home run
q = 0.95, probability of not a home run
n = number of investments

One way to answer this is to calculate the mean number of failures before the first success. In other words, on average how many investments will not be a home run before one that is? This is represented with the formula:

(1-p) / p = (1-0.05) / 0.05 = 19

You need to make, on average, 19 (!!!) investments before you will have a home run.

Another way to think about this is to calculate the probability of having at least 1 home run after a certain number of investments, which is represented by the formula:

P(>=1 Home Run) = 1 – ((1-p) ^ n)

For example, with 5 investments (n=5) your odds of having at least 1 home run are:

1 – ((1-0.05) ^ 5) = 22.6%

Your odds increase to 40% with 10 investments and 92.3% with 50 investments. The graph below illustrates the full distribution.

Screenshot 2016-06-12 21.11.07


  • Most investments will fail; accept it
  • Home runs are integral to financial success
  • Lots of investments are needed to find home runs; I suggest 30+ giving you about 80% probability of having at least 1 home run

Have a basic strategy

You wouldn’t start a business without a plan; don’t start angel investing without one either. Here are some things you should consider up front:

Bankroll management, Number of investments, Unit size

Decide how much you want to invest. This might be in proportion to your liquid assets or your yearly income (or both). How to choose an amount is outside the scope of this post, but you can find more info on this topic in the Additional Reading section below. For simple math, let’s assume you’ve decided to invest $1 million. This is your bankroll.

Hopefully I’ve convinced you the number of investments should be at least 30, but you should decide on a number. Let’s assume you’ve picked 40. (Note: it’s okay to stretch this over a long period of 5-10 years of investing).

So how much should you invest in each company? $1 million divide by 40 = $25,000, right? Wrong. Because you need to reserve for follow-on funding (more on this below), your Unit size should be (Bankroll / Number of investments / 2), or in our example ($1 million / 40 / 2) = $12,500. This should be your initial investment in each company with no (or very little) deviation.

Investment focus

What kinds of companies do you want to invest in (medical device, SaaS, consumer Internet, marketplaces, etc.)? What stage of company do you want to invest in (pre-product, product but pre-revenue, revenue but pre-scale, etc.)? Having at least broad views on these questions will help you effectively allocate time and make decisions. For example, I do not invest in pre-product (idea only) stage companies and am generally averse to pre-revenue stage companies.

Follow-on funding

As an angel investor, you’re generally going to be the first outside funding into the company. Most successful companies, especially those who go on to be home runs, will require additional funding. To maximize your financial return from these companies, you should participate in their future funding rounds, which is why you need to reserve funds in your bankroll to do so. Doubling, tripling, even quadrupling down on your successful investments will be common and should be part of your basic strategy.

Remember dividing by 2 in the formula above? Here’s how I arrive at that conclusion:

Total investments: 40
Of the 70% that fail (28), half (14) will never gain traction to raise additional funding, but the other half (14) will. [14 additional units]
Of the 30% that succeed (12), all will raise additional funding. [12 additional units]
Of the 30% that succeed (12), half (6) will raise additional funding more than once. [10 additional units]
Total additional units: 36, rounded up to 40


  • Determine your bankroll, number of investments, and unit size
  • Have general thoughts about what types of companies you want to invest in
  • Be prepared to participate in future funding runds of your companies

Getting started is more important than being an expert

There’s a lot to learn. How do you determine fair valuation for an early stage company? When are convertible notes a good alternative to a priced equity round? Which terms in the complex transaction docs are most important? What are the pros & cons of investing in LLCs vs. C-Corps? All of these topics are important, and becoming an expert in them will make you a better angel investor.

But here’s the thing. I’ve been an entrepreneur for 15 years, been through the capital raise process multiple times, been an angel investor for 3 years, and have made more than 15 angel investments. And I still learn something new with every investment I make.

So by all means learn about these topics, but I’m suggesting you’re much better off learning these nuances by actually making investments than trying to learn in a bubble.

Following others is a good beginners strategy

Making your first angel investment can be an intimidating process. I’m suggesting that networking with and following other experienced investors is a good strategy for beginners to get started. Experienced investors can help navigate you through the process while offering advice along the way. Feedback and wisdom from other investors was invaluable to me when I was getting started.

By following other investors, I mean: pursuing the deals they pursue; talking to companies with them instead of by yourself; understanding the questions they ask and why; understanding what’s important to them and why; etc. I do not mean blindly following and investing in companies solely because another investor did. (Though it’s not a completely crazy strategy).

Actionable steps to get started

Here are some things you can do, in some cases right now, to get started:

  • Network with other local angel investors (LinkedIn Search, AngelList Directory) and VCs.
  • Join AngelList and create a profile. If your Unit size is below what companies typically accept directly ($10k-$25K), investing in AngelList Syndicates is a good alternative.
  • Join Gopher Angels, a network of angel investors. Benefits include networking with other investors, access to deal flow, and ongoing education.
  • Attend the SeedMN event (date TBD). Tell the organizer, Casey Allen, you want to attend.
  • Attend the next ACA event in Minneapolis.

Further reading that I’ve found useful from though leaders in the industry: