What is a convertible note?

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A convertible note is an investment vehicle often used by seed investors investing in startups
who wish to delay establishing a valuation for that startup until a later round of funding or
milestone. Convertible notes are structured as loans with the intention of converting to equity.
The outstanding balance of the loan is automatically converted to equity at a specific
milestone, often at the valuation of a later funding round. In order to compensate the angel
investor for the additional risk of investing in the earlier round, convertible notes will
sometimes have additional clauses, such as caps, and or discounts.

Why do startups raise investment capital using convertible notes? Link

Convertible notes (or notes) offer a simple, cheap, and fast method for startup funding as
compared to traditional priced equity rounds. It also defers the more complex discussion of
startup valuation to the next round of financing as convertible notes do not set the exact terms
of the investment.

What are the key parameters in a convertible note? Link

There are many possible terms in a convertible note (or note). The two most important ones
in general are the conversion valuation cap (or cap) and the conversion discount (or
discount).

What is a discount in a convertible note? Link

A discount in a note sets a percentage reduction at which the convertible note will convert
relative to the next qualified priced round. Effectively this permits an investor to convert the
principal amount of their loan (plus any accrued interest) into shares of stock at a discount to
the purchase price paid by investors in that round. Discounts range from 0% to as high as
35% with 20% being common.

What is a cap in a convertible note? Link

A convertible note cap sets the maximum valuation at which the investment made via the
convertible note can convert into equity. Investors in the convertible note typically get
converted at the lesser of the valuation of the next qualified priced round and the cap.

What if the convertible note has both a discount and a cap? Link
For notes that include both a discount and a cap, the notes will typically specify that the
conversion price will be the lower of the price per share determined by the discount to the
next qualified priced round price per share OR the price per share determined by dividing the
cap by the next qualified priced round pre-money valuation. The lower of means that the
investor receives the better of the two possibilities (lower conversion price per share means
that the note converts into more shares in the Series A).

Numerical Example: $25k convertible note with $5M cap, no discount Link
Lets do a numerical example ignoring any accrued interest:

1. You invest $25k in a startups seed round using a convertible note with a $5M cap
2. At the Series A, the startup raises money from a venture capital firm that invests at a
pre-money valuation of $10M with a per share price of $5.00
3. Your $25k loan would convert into shares of Series A Preferred Stock at a price of
$2.50 per share ($5M cap divided by $10M pre-money valuation) which gives 10,000
shares of Series A Preferred Stock ($25,000 divided by $2.50/share); a new Series A
investor would receive only 5000 shares of Series A Preferred Stock for $25k
4. On paper, your 10,000 shares at $5.00/share are worth $50,000 which is an unrealized
return of 100%
5. If the pre-money valuation were higher at $20M, your $25k note would convert at
$1.25/share ($5M cap divided by $20M) into 20,000 ($25k divided by $1.25) Series A
shares worth $100,000 for a paper unrealized return of 300%

Numerical Examples: $25k convertible note with $5M cap, 20% discount Link
Lets do numerical example ignoring any accrued interest:
1. You invest $25k in a startups seed round using a convertible note with a $5M cap,
20% discount
2. If, at the Series A, the startup raises money from a venture capital firm that invests at
a pre-money valuation of $10M with a per share price of $5.00 IF we apply the
discount, the price per share would be $4.00/share ($5.00 times (1 minus 20%)) IF we
apply the cap, the price per share would be $2.50/share ($5.00 times ($5M cap
divided by $10M pre-money valuation)) THUS the cap would apply and the note
would convert at $2.50/share which gives 10,000 shares of Series A Preferred Stock
($25,000 divided by $2.50/share). On paper, your 10,000 shares at $5.00/share are
worth $50,000 which is an unrealized return of 100%
3. If, at the Series A, the startup raises money from a venture capital firm that invests at
a pre-money valuation of $6M with a per share price of $5.00 IF we apply the
discount, the price per share would be $4.00/share ($5.00 times (1 minus 20%)) IF we
apply the cap, the price per share would be $4.1667/share ($5.00 times ($5M cap
divided by $6M pre-money valuation)) THUS the discount would apply and the note
would convert at $4.00/share which gives 6,250 shares of Series A Preferred Stock
($25,000 divided by $4.00/share). On paper, your 6,250 shares at $5.00/share are
worth $31,250 which is an unrealized return of 25%

Numerical Example: $25k convertible note with no cap, 20% discount Link
Lets do a simple numerical example ignoring any accrued interest:
1. You invest $25k in a startups seed round using a convertible note with a 20%
discount
2. At the Series A, the startup raises money from a venture capital firm that pays $5.00
per share of Series A Preferred Stock
3. Your $25k loan would convert into shares of Series A Preferred Stock at a price of
$4.00 per share ($5.00 times (1 minus 20%)) which gives 6250 shares of Series A

Preferred Stock ($25,000 divided by $4.00/share); a new Series A investor would

receive only 5000 shares of Series A Preferred Stock for $25k
4. On paper, your 6,250 shares at $5.00/share are worth $31,250 which is an unrealized
return of 25%

What is warrant coverage in a convertible note? Link

Warrant coverage in a convertible note gives an investor the right to purchase additional
shares of stock in a company. Typically, this is based on some percentage of the principal
amount of the loan (plus any accrued interest) and this additional purchase option happens at
the point of conversion of the note from debt into equity. The terms vary based on the note.

Numerical example: $25k convertible note with 10% warrant coverage Link
Lets do a numerical example ignoring any accrued interest, and assuming no valuation cap
or discount in the convertible note:
1. You invest $25k in a startups seed round using a convertible note with 10% warrant
coverage for shares of the next round at the price of the next round
2. At the Series A, the startup raises money from a venture capital firm that pays $5.00
per share of Series A Preferred Stock
3. Your $25k loan would convert into shares of Series A Preferred Stock at a price of
$5.00 per share = 5,000 shares
4. Additionally, you would have the option to purchases shares from 10% warrant
coverage or an additional 500 shares (($25,000 * 10%)/$5/share).
5. If purchase option is fully exercised, you would have a total of 5,500 shares in the
new round, or 10% more than you would have otherwise had from the convertible
note.