A convertible note is a loan that starts from short-term debt and is converted into equity. Just like a traditional business loan, there are certain terms to keep in mind as you work with investors.
We are going to define and further explain these key terms relating to convertible notes.
The first term is valuation cap, generally referred to as the “cap”. The cap is the maximum value at which the loan converts into equity. This value includes the initial investment and the interest.
For example, if the valuation cap is one million and the company is valued at $2,000,000 during the next investment round, then the investment would convert at $1,000,000.
Conversely, if the company is valued at $500,000 and the cap is $1,000,000, then the equity converts at $500,000. The investment always converts at the lower amount. Therefore, as a founder, you want to keep the cap as high as possible.
The lower the cap, the better the terms for the investor, since their initial investment will convert into a greater amount of equity. Think about it. Would you prefer for something to cost more or less?
The next term is the discount rate. A discount rate is an incentive and reward mechanism for early investors who are taking on the risk of investing in an early-stage company.
Investors who give capital earlier are offered a discount on the share price to offset the additional risk of coming in early to a company. This discount is anywhere from 10% to 20% depending on the industry and what the investor values most.
Usually, a convertible note will include a valuation cap and a discount. This, however, is not required. If the valuation cap is set lower, then the discount should also be lower or vice versa. These are all things that can be negotiated.
The next term is the maturity date. The maturity date of a convertible note is the date on which the note is due and needs to be repaid to investors.
Trigger Event. A trigger event for convertible notes is when the note will convert from short term debt to equity. This usually occurs during the next investment round when a valuation has been set.
An interest rate on a convertible note is how much interest on the principal investment accrues prior to converting to equity. Interest rates are not as significant in comparison to traditional loans. The interest rates on convertible notes are usually low and can be negotiated to zero depending on what the investor values most.
The key takeaways from today’s video are:
- Convertible notes are loans that start as short-term debt but turn into equity
- Valuation cap is the maximum valuation amount that the convertible note investment will turn into
- The discount rate is a discount given to incentivize early investors and offset the added risk
- The maturity date is the date that a convertible note must be repaid by
- A trigger event is when a convertible note turns into equity
- An interest rate shows how much interest is given to an investor prior to converting to equity