In return for $250K of seed capital, an angel investor is asking for a 20% discount, a 5% interest rate and a $4M cap using a standard convertible note agreement. What might these terms mean at series A when the note converts? In this post, we walk you through a simple, visual fundraising scenario.
First, a little background on notes…
Convertible notes establish a legal agreement between a startup, typically seed stage, and an investor. This agreement is structured as a loan (principal plus interest) but gives the investor the right to convert his or her debt into equity if, for example, the company raises a round of venture capital or sells the business.
The two main advantages of convertible notes are their legal simplicity and the fact that they do not price the company. They are a way for founders and seed stage investors to quickly agree on an investment and punt legal complexity and deliberation over company value to a later equity financing round.
If you don’t manage your convertible notes carefully, it’s possible to end up giving away more equity than you had planned.
Convertible notes, however, do have some important terms that make a difference at series A. It pays to understand the impact of these terms.
Let’s look at our example…
Time Capsule is a seed stage startup with a very simple equity structure; 2 founders, each with 3M shares. Here is the Time Capsule company cap table:
The cap table includes 2 standard convertible notes. The first note models a typical angel investor’s terms: $250k principal, 5% interest rate, 20% discount rate, and a $4M valuation cap. The second note shows almost identical terms but lowers the valuation cap to $2M.
What’s the impact of the different cap sizes at series A?
Let’s look at a fundraising scenario where the investors are offering $1M of investment on a $4M pre-money valuation. Below you see a view of the round with just the first $4M capped note converting. The blue layer in the stack shows the impact of this note.
Here is more detail on the ownership structure after this round — The angel investor gets 588,235 shares or 6.25% of the company for their $4M capped note.
Let’s look at the same scenario but this time with the lower, $2M valuation cap note. After the round we see that the angel investor has earned 1M shares or 10% of the company.
Observe how the 2 notes, identical in all ways except for the cap amount, convert to significantly different numbers of shares and % ownership at series A.
So what exactly is driving the difference?
In the table above, we see the column Effective Discount. In the case of the $4M capped note this discount is 20% — the rate defined in the terms of the note. However, the $2M capped note has an effective discount of 50%. Where is this higher 50% discount coming from?
This higher value is actually being dictated by the note’s $2M cap. Because the valuation cap is set at $2M and the actual valuation is $4M, this cap will deliver a whopping 50% ($2M / $4M = 50%) of effective discount.
Even though a note has both terms; the discount and the cap, only one term is ultimately utilized — whichever yields the greatest effective discount.
What if the series A were to have a much higher pre-money valuation, e.g., $10M? How much equity would each of the 2 notes convert to? What difference do the 2 different cap amounts make in this scenario? What about a very small round of $2M or even $1M?
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