Convertible Notes For Startups and Investors
Top 3 Things You Need To Know About How Convertible Notes Work
What is a convertible note?
Here are three things you need to know. First, the definition: A convertible note is a loan. Sounds like a car, it's a convertible. No, it's an actual loan. It converts an equity after the company has completed additional rounds of funding.
What does that mean? When you invest in a company, usually the convertible note has what's called a cap. There's an evaluation that's met and once they have an up round, or a high evaluation, and another fund raised then your original investment turns into stock and you got essentially a discount for the most part. It's essentially a loan. It converts into equity and additional rounds of funding.
Here are the most important things you need to know. Number one, convertible note is most often used in seed rounds because they delay determining how much a company's worth until better metrics and evaluation principles are present. Important. Number two, when you invest in a convertible note, the startup receives the money right away. The number of shares you're entitled to is determined on the next round, usually Series A. As investors at Angel Kings, when we find awesome startups we say, "Look, you can use whatever document you want. Are your people, your product execution, time and all the important things we talk about in our book, Kings Over Aces, there?" Important to note that the startup receives the money right away but the number of shares you're entitled to as the investor come later. That's okay. Convertible notes absolutely work. We've seen some phenomenally successful companies using convertible notes and then getting to a higher round. Third thing, once the Series A investors have determined a price, your loan converts into shares at a discount. The Series A price rewards you.
When you invest in a convertible note, the startup receives the money right away.
If you invest in startups, you know that there's high risk high reward. Nothing is guaranteed. When you see a convertible note, you take that risk. Meaning they said it's worth ten million pre-money and they're raising two million so post-money that's twelve million dollars. That's the evaluation. If you don't have that exact evaluation or straight up equity, you're taking a little bit of a risk. It works out in the sense that, you eventually get the equity that you deserve plus a little bit of extra if there is what's called a discount. I look for discounts. I think there should be one that's built into the convertible note documents. Those are the three main points.
The amount of equity the note converts to depends on the price of "A" round. You start with seed round, then you go to Series A. Then you go to series B, C, etc, etc, etc. until you have what's called an liquidity event. Either merge, or sale, or in the IPO, etc. There has to be an up round for the convertible note to convert. By the way, there's a handful of important terms that you need to know that you'll see in the documents.
You eventually get the equity that you deserve plus a little bit of extra if there is what's called a discount.
Discount rate. If you see the word or the phrase discount rate, it's based on how much risk you took by investing in prior rounds. With a twenty percent discount rate (very common) and the "A" round investors investing in a price of one dollar per share. Your note will convert into equity at .80, so an .80 cents per share and you'll receive twenty-five percent more shares of that price. Twenty percent discount, "A" round investing at one dollar per share, your note will convert at eighty cents per share and you'll receive twenty-five percent more shares at that price. That's the essence of a discount rate.
Evaluation cap. Evaluation cap sets the maximum price your loan will convert into equity. How does a convertible note convert? How did discount rate and evaluation cap work together? Notes convert either using a discount rate or evaluation cap, whichever is best for investors. Convertible notes are loans and you'll receive the appreciative value of the original loan in the next round. I've mentioned this before earlier. You're not investing for interest. You can do that on a public market, although it does help long-term for some investors. Especially if there's a long-term potential play here. Maybe you're investing in a moon shot that might take ten, twenty years then it could be more valuable. There's a maturity date that you need to be aware of. The bottom line is, don't invest unless you have somebody like us on your side. Somebody, at the very least, who understands what a convertible note is and how it effects your rights both as a startup and an investor.