When negotiating a convertible note or a convertible equity instrument, there are a few key terms in the negotiation that are significant for the investor and the entrepreneur. In a previous article, we discussed the differences between convertible notes and convertible equity. This article discusses the important terms in convertible notes and convertible equity, including the cap and the discount.
What are the Most Important Terms in Convertible Notes and Convertible Equity?
There are two key terms that are generally the provisions in a convertible note or convertible equity instrument that are the most significantly debated at the time of the deal: the cap and the discount. In addition, there are several other important terms in convertible notes and convertible equity. Each of these are discussed below.
In a convertible note, the cap is the maximum valuation at which the shares will convert to equity. In other words, if the valuation at the time of conversion is higher than the cap, the holder of the convertible note will receive the percentage of shares that she would receive if the valuation was equal to the cap. If the valuation is lower than the cap, then the cap does not come into play.
This is better explained through an example: a convertible note issued by a startup has a $4 million cap. The startup raises a Series A round at a pre-money valuation of $8 million with a price per share of $4.00. The convertible note holder would be able to convert at a price of $2.00 per share (the value of the cap divided by the Series A valuation). If the startup raised less than $4 million, the cap would not come into play at all.
Caps range significantly, with common caps ranging from $4-8 million.
The discount rewards the convertible note holder for taking a risk on an early stage company by allowing the holder of the note to convert at a lower price than the investors pay at the conversion round. Again, an example will explain this: a $20k convertible note issued by a startup has a 20% discount. The startup raises a Series A round with a price per share of $10.00. The note holder would be able to convert at a price of $8.00 per share (20% less than the value paid by the investors at the time of conversion) and receive 2,500 shares (not taking into account any interest or cap).
Again, discounts range significantly between 0% and 35%, with the most common discount being around 20%.
How the Cap and the Discount Interact
When there is both a cap and a discount, generally the convertible note specifies that the investor will receive the shares at the lower price mandated by either the cap or the discount. Here is an example: a $20k convertible note has a 20% discount and a $4 million cap. The startup raises a Series A round based on a pre-money valuation of $10 million with a price per share of $10.00. The cap would allow the note holder to convert at the value of $4.00 per share. The discount would allow the note holder to convert at the value of $8.00 per share. Thus, assuming that the note specifies that the shares will be issued at the lower of the price allowed by either the cap or the discount, then the note holder will be able to convert at the price of $4.00 per share.
What are Some Other Important Terms in Convertible Notes and Convertible Equity?
Here are a few other important terms to consider in convertible notes and convertible equity:
Terms Applicable Only to Convertible Notes:
- Time to Maturity: the duration of the debt instrument (i.e. when the note holder can “call the note” and demand repayment) – this is typically between 1-2 years;
- Interest Rate: the interest rate attached to the debt that will accrue over time (and will be incorporated into the conversion) – this ranges significantly between 2 or 3% and 10+%; and
- Ability to Pre-Pay: the startup may or may not be permitted to pre-pay the loan back to the investor instead of allowing the investor to convert the loan into equity.
Terms Applicable to Both Convertible Notes and Convertible Equity:
- Rights Upon Acquisition: usually the investor will be paid back extra upon an acquisition of the startup by another company;
- Conversion Event: the definition of the round at which the conversion occurs (this is usually described as a minimum aggregate investment); and
- Warrants or Other Future Rights: to entice investors to take a risk on an early-stage startup, the investor will sometimes receive warrants that allow the investor to purchase additional stock at a future date.
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DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.