Convertible Notes for Startups: A Comprehensive Guide
Overview
Convertible notes are an alternative financing option for startups, especially those with little to no revenue or profitability. They share similarities with SAFE notes but have distinct mechanics and nuances. In this post, we'll delve into the mechanics, key features, and comparisons with SAFE notes to help startups make informed decisions about their funding and growth strategy.
Mechanics of Convertible Notes
Convertible notes involve raising cash from investors without issuing new shares initially. They have attached interest, which accrues to the loan principle, making them a true debt instrument with a maturity date. This means convertible notes have a higher claim to assets than equity investors, including preferred equity investors.
Key Features
Unlike SAFE notes, convertible notes do not set a specific valuation in the initial round. However, they have a higher potential dilution due to accrued interest, which increases the convertible note balance over time, leading to more shares upon conversion.
Example in Excel
Let's consider a seed round where convertible note holders invest $2 million with a 20% conversion discount, $10 million valuation cap, and 10% accrued interest rate. After two years, the convertible note principle increases to $2.4 million due to accrued interest. In the series A round, the convertible note holders receive more shares (403,000) than they would have without accrued interest (333,000).
Comparison to SAFE Notes
Convertible notes share similarities with SAFE notes, including deferring valuation and not issuing new shares initially. However, convertible notes have attached interest, which increases the convertible note balance over time, leading to higher potential dilution.
Convertible Notes in Seed Rounds
In a seed round, convertible notes do not receive any shares. The valuation cap sets the maximum valuation convertible note investors can get their shares at in the next priced round. The conversion discount determines the discount to the share price convertible note investors can get their shares at in the next priced round.
Conversions in Series A with Options Pool
In the series A round, convertible note investors invest $5 million at a $10 million pre-money valuation. The convertible note investors get a certain price per share, calculated by determining the price per share they get. New shares are issued to each group in this round, and the options pool is factored in and grossed up based on the free options given out to employees.
How it Works in Excel
The post-money valuation is calculated by adding the investment size to the pre-money valuation. The share price is calculated by dividing the pre-money valuation by the total number of shares that existed before the round. The convertible note investors' original principal is factored in, along with the accrued interest, before calculating the conversion price.
Key Differences between Convertible Notes and Safe Notes
Convertible notes have a higher dilution potential due to the accrued interest component. They are more like venture debt and can be used as bridge loans, whereas SAFE notes are used in seed rounds. The conversion triggers for convertible notes are different from those for SAFE notes, with priced rounds being one possible trigger.
Should Startups Consider Using Convertible Notes or Safe Notes?
It depends on the startup's situation and needs. In the current environment, neither convertible notes nor SAFE notes may be ideal for all startups.
Calculating Purchase Price per Share
For convertible note investors, the purchase price per share is calculated based on either the discount or the valuation cap. If using the discount method, the series A price per share is multiplied by (1 - 20% discount). If using the valuation cap, the valuation cap (10 million) is divided by the total number of shares before this round. The convertible note investors will choose the discount method, as it results in a lower purchase price per share ($6 vs. $750).
Seed and Series A Investors
For seed investors, the convertible note principal is divided by the purchase price per share to determine the number of shares. For series A investors, their $5 million investment is divided by the series A share price to determine the number of shares. The total number of shares for both groups is approximately 1.07 million.
Valuations and Return on Investment
The valuation of the company is determined by dividing the valuation by the initial investment of $2 million. The convertible note investors receive a substantial return on their investment due to the accrued interest and substantial discount.
Options and Employee Shares
The non-option shares are added to determine the total number of shares created or purchased in this round. The employees receive 20% of the company for free, which is grossed up to a higher number by dividing by (1 - 20%). The total number of new options is approximately 434,000.
Post-Money Valuation and Cap Table
The post-money valuation is determined by multiplying the total number of shares by the share price in the round ($7.50). The result is a post-money valuation of approximately 21.3 million, which is higher than the expected 15 million due to the convertible note investors and option pool. The series A investors own approximately 24% of the company, whereas they expected to own 33%. The founders' ownership is reduced from 90% to 42%.
Dollars Invested Method
The dollars invested method is an alternate calculation for determining the post-money valuation, which results in a lower number. This method involves dividing the investment size by the pre-money valuation, and is an alternative to the discount method used in this calculation.
Convertible Notes vs. SAFE Notes: A Comparison for Startups
When using the convertible note principle, subtract the investment in this round, the convertible note value, and the employee options pool to get a lower pre-money valuation. This method leads to a different calculation of shares, resulting in seed investors owning 17% and series A investors owning about 29%.
Dilution Comparison
A side-by-side comparison of the convertible note and SAFE note options shows that the convertible note creates more dilution. In the example given, seed investors own 12% of the company with a SAFE note, but 14% with a convertible note.
Advantages of Convertible Notes
Clear treatment in the case of company shutdown or liquidation: convertible notes are debt and senior to all preferred and common equity. They can be used in more cases, and sometimes act like bridge loans similar to venture debt. They are senior to SAFE notes and preferred and common equity.
Opinions on Convertible Notes
The speaker believes that convertible notes are not worth it for startups, as they favor investors more than SAFE notes. Convertible notes have diminishing advantages over time, as investors have gotten better at standardizing terms in priced equity rounds.
Recap and Summary
Convertible notes in the seed round have no impact on the cap table. In the series A round, convertible notes create more dilution than SAFE notes. The speaker does not think either convertible notes or SAFE notes are great for startups, but if they want to move quickly and have a preference for one, they can still use them.