How Does Convertible Debt Work?
Many tech startups in the U.S. raise seed capital through convertible notes – in fact, I’ve used them about a dozen times for various seed financings I’ve done prior to a Series A Preferred venture capital raise. Because of its popularity,
we built this type of complex early-stage financing into our app so you can easily see the impact of adding a convertible seed note on your business plan financial model, financial statements, and cap table.
Why Convertible Debt is Popular
A seed investment in the form of a convertible note is typically used when an entrepreneur needs to take in a smaller initial financing prior to a venture capital investment round in the form of a promissory note that then eventually converts into the next financing round, usually at a premium. This type of financing is often referred to as “venture debt”, “bridge financing”, or a “bridge loan” and is very useful in situations where the company needs a fast and low-cost investment without all of the cost and legal documents required for a Series A Preferred investment round and without the hassle of establishing or negotiating a valuation for the company.
The convertible debt then “converts” into the Series A Preferred investment round that is led by an institutional venture capital fund that performs the standard due diligence, negotiates the valuation and terms of the deal, and the convertible note ends up being part of the larger funding.
Why Entrepreneurs Like Convertible Debt
A convertible note is typical far faster, cheaper, and easier to structure, negotiate, and close than a typical Seed round or Series A Preferred venture capital round of investment. The downside is that if the process of trying to close a Series A continues to drag on, the convertible note interest can start to pile up in a meaningful way and the seed investor can become rather restless. Many convertible notes has a one-year term and then are fully due and payable, which means you either got your Series A funding or you shut down and the seed investor/lender ends up with any leftovers.
Why Angel Investors Like Convertible Debt
A convertible note provides more downside protection in that the company and its assets are guaranteeing the loan. So if the Series A doesn’t happen, at least the investor may end up with some interest or some assets rather than just throwing away common stock certificates. Additionally, seed investors investing in a normal common stock seed round without any of the typical Series A Preferred protections and preferences can easily find themselves under a lot of overhang once the Series A comes in. For example, a $25 million Series A Preferred with a 1.5x liquidation preference means $37.5 million gets paid out to the Series A investor at liquidation prior to the seed investor getting anything, while if the seed investors $1 million converts into Series A, they are now pari passu (same deal without bias) investors with the Series A and have all of the same protections and preferences as the institutional venture capital firm.
Typical Convertible Debt Terms
The typical terms for a seed capital investment in a startup in the form of a convertible note include the following:
Investment/Principal – The total amount investment or lent to the company under the note, such as $1 million
Annual Interest Rate – Convertible notes usually carry a simple annual interest and in my experience range from 5% to 15% annually. The interest is almost always deferred and simply accumulates until the conversion.
Disposition of the Interest Due at Conversion – A convertible note agreement may call for the investor to get cashed out on the interest while they convert their principal, but usually both interest and principle are converted into the Series A.
Conversion Discount – The Conversion Discount is the discount rate applied to the pre-money company’s valuation for purposes of calculating a conversion price. This is expressed as a percentage such as “20%”. Formula: The Conversion Discount formula is expressed as follows: (Pre-Money Valuation x Conversion Discount) / # of Fully-Diluted Shares
Conversion Cap – The Conversion Cap is a pre-determined maximum pre-money valuation of the company at which the Convertible Note converts to Series A equity. This is expressed as a total pre-money valuation such as “$2,500,000”. Formula: The Conversion Cap formula is expressed as follows: Conversion Cap Valuation / # of Fully-Diluted Shares
Example: Let’s say a startup looks like this prior to taking on the Convertible Note:
Total Founder’s Shares: 1 million
Total Options/Warrants Outstanding: None
Total # of Fully-Diluted Shares: 1 million
Now, let's say the startup agrees to the following Convertible Note terms:
Investment/Principal: $2 million
Interest Rate: 15%
Disposition of Interest: Converted into Series A
Conversion Discount: 25%
Conversion Cap: $4 million
Finally, let's say the startup then raises a Series A preferred round of financing as follows:
Series A Investment: $5 million
Series A Pre-Money Valuation: $5 million
Series A Shares to Series A Investor: 1 million
Series A Price/Share: $5.00/share
Given the above assumptions, the conversion would work as follows:
Total Deferred Interest on Convertible Note at the Time of Conversion 3 Months Later: $75,000 ($2 million x 15% x 3/12 = $75,000)
Conversion Price Based on Conversion Discount: $3.75/share (($5,000,000 x 25%) / 1,000,000 = $1.25, $5.00 - $1.25 = $3.75)
Conversion Price Based on Conversion Cap: $4.00/share ($4,000,000 / 1,000,000 = $4.00)
Note that the Convertible Note seed investor will almost always get the lower share price of all three pricing formulas – whichever is most advantageous for them – the Series A pricing, the Conversion Discount pricing, or the Conversion Cap pricing. Because of that, in the above example, the seed investor will pay the price based upon the Conversion Discount, or $3.75/share, instead of the Conversion Cap price of $4.00/share, or the Series A price of $5.00.
Therefore the seed investor at the time of the conversion gets the following # of shares of Series A Preferred stock:
$2 million principal conversion priced at $3.75 = 533,333 shares
$75,000 of deferred interest conversion priced at $3.75 = 20,000 shares
Total: 553,333 shares
Now, while all of the above may sound a bit daunting for a startup entrepreneur, we made this very, very easy in our Startup Financial Model web app. All you have to do is enter the five typical convertible debt terms listed into a simple input form and your business plan financial model and all of its accompanying financial statements, financial ratios, cap table, pitch deck financial summary, investor return analysis, and any downloaded spreadsheet or worksheet reports will properly reflect the output of the complex set of transactions.
You can see more details on how this works in our Startup Financial Model app in this support blog post.