Practical advice on convertible notes

Are you issuing a convertible note? Are you doing it to avoid the headaches of setting a valuation on your startup? Well.. think again! Convertible notes bring their own set of calculations and negotiation and for the sake of yourself and your startup, you should pay as much attention to them as to any valuation negotiation.

A lot has been said about the pros and cons of convertibles. One pro is the fact that no valuation needs to be calculated, when we all know that everybody makes their own valuation assessment to determine the percentage of ownership upon conversion.

Indeed, in most cases, the terms of the convertible hide valuation information and make it just more fuzzy. A lot of articles have warned entrepreneurs about wrong usages of this instrument. The general consensus seems to be around a limited usage of them, with some corner cases, like bridge financing, for which they are perfect.

But if you must use them, you should at least be aware of the most common terms and their implications on the future of your stake and your company.

But what is a convertible note?

A convertible note is a contract between the company and an investor that stipulates that the investor provides the company with capital in the form of debt. The second and most important stipulation is then the conversion. When a predetermined “trigger event” happens, the debt gets converted into equity (in other words the notes get converted into shares) and the convertible note holder becomes a shareholder.

As a private contract between two parties, almost any clause can be applicable. Through the years and the usage of the instrument, contracts got more and more standardised and now contain certain common terms and themes. However, bear in mind that uncommon clauses can still be added by both parties and that the final contract might look quite far from the standard one.

Here is a detailed explanation on how they work:

Both you and your investors should do some scenario analysis on what are the outcomes for different levels of these inputs.

On top of this, you probably have an idea regarding the trigger valuation. And so does your investor. The relationship between the final equity stakes are then pivotal to understand.

The higher the final valuation, the lower the stake for the convertible note holders. This unless the valuation is above the cap. In this case, convertible note holders will receive the same equity stake, thus ideally benefitting from a higher valuation, as their shares will be worth more.

This implies that investors interested in buying convertible notes will keep the cap low, and the discount high. While you and the founding team will strive for the opposite.

Data on early stage discounts and caps is not readily available, making the misinformed entrepreneur the less informed part. In all these operations, it is always better to consult with other founders, lawyers or advisors on these terms to avoid surprises in the future.

When discussion on the cap gets central in the negotiation, a lot of questions about valuation will surface. Also for this part of the discussion, we entrepreneurs are usually less informed than the other part. And also for this part we should check with other founders, lawyers or Google.

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Conclusion

Convertible notes are generally constituted of simpler calculation and math. They are more flexible contracts compared to shareholder agreements and other things. However, for the most part, they hide a lot of complexity and leave it for future discussions. Use them with discretion and try to forecast as much as possible the different outcomes.

This article was originally published on Equidam