Startup Financing–The Convertible Note
Many startup founders believe they can avoid locking in a valuation during seed funding by deferring valuation in the form of a convertible note. Convertible notes do place less emphasis on valuation and yet most seed investors will insist on a cap. The cap in effect is a valuation.
So here’s what you have to know about the convertible note:
- The Note – A convertible note is a loan document that under certain provisions will convert to stock.
- Interest – The note is an interest-bearing document that depending on the quality of the company will pay from 6% – 10% interest.
- Conversion – The note will define a triggering event that will force the conversion to stock.
- Triggering Event – The triggering event is typically defined as a qualifying financing which means a round of financing of a defined dollar value of preferred stock. The example of trigger language would be, “For purposes of this Note, a “Qualified Financing” will mean a private placement of any shares of its preferred equity securities for an aggregate gross proceeds of $500,000 or more (inclusive of the conversion of the Notes).
- Discount – To provide incentive to the Note Holder for investing early, they receive a discount in the case of a “Qualifying Event” or trigger. Discounts range from 15 – 20 percent.
- Cap – This is where valuation comes in. Angel investors will require a cap which translates to a valuation. For instance, if the cap is $2 million, then when a Venture Capitalist invests a million dollar in the company, at a valuation of $5 million, the note holder’s money will convert at the $2 million cap.