How Convertible Notes Work

How Convertible Notes Work

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  1 How Convertible NotesWork #ConvertibleNotes SEEDCHANGE
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  About Your Hosts KevinSmith Founder and CEO Gadiel Morantes Partner SEEDCHANGE
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  What’s a convertiblenote (and why should you care)? 3www.seedchange.com www.earlygrowthfinancialservices.com • Historically used for bridge rounds • Now standard for early stage funding (unless you’re in ROW) • When to use convertible notes: – Seed – Bridge – Supplement
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  Startup funding cycle 4www.seedchange.comwww.earlygrowthfinancialservices.com
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  Looks like afish, flies like a bird. . . . 5 • Debt / equity hybrid • Technically debt (interest and terms) • Behaves (mostly) like stock: will convert when the company does a sizeable equity investment round www.seedchange.com www.earlygrowthfinancialservices.com IOU
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  The FAB ofconvertible notes— Features 6 • Short agreement • Simple • Flexible • No company valuation • (Largely) standardized terms www.seedchange.com www.earlygrowthfinancialservices.com
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  Advantages of convertiblenotes 7 • Short  Quick close(s) • Simple  Low legal fees • Flexible  Close any time • No valuation  No negotiation • Standard terms  No negotiation www.seedchange.com www.earlygrowthfinancialservices.com
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  Benefits of convertiblenotes 8 • Short  Quick close(s)  Save time • Simple  Low legal fees  Save $ • Flexible  Close any time  JIT funding • No valuation  No negotiation  Save $/time • Standard terms  No negotiation Save $/time www.seedchange.com www.earlygrowthfinancialservices.com
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  How it works:a 1-page manual 9 • Decide amount of round and minimum investment • Provide note terms to (accredited) investor • Agree terms • Sign and date – the note purchase agreement (company and investor) and – the note (company) • Exchange executed note purchase agreement and note for check/wire • Add noteholder to cap table (debt page) Convertible note is classified as debt until it converts to equity www.seedchange.com www.earlygrowthfinancialservices.com
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  All the termsthat matter 10www.seedchange.com www.earlygrowthfinancialservices.com • Interest rate • Note term (Maturity date) • Discount • Note cap
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  Interest rate 11 • Allconvertible notes include interest rate: IRS says so • Methods for determining the interest rate: – Round number: 5% – Tied to accepted standard: LIBOR • Interest is paid in shares, not cash • Interest begins to accrue on the date the note is signed • Interest is paid when the note converts to stock www.seedchange.com www.earlygrowthfinancialservices.com Use 5%
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  Term (Maturity date) 12 •Date of conversion/repayment • Typically converts after 12 or 18 months • On maturity • Convert or repay • If neither, talk to your investors about amending the note purchase agreement www.seedchange.com www.earlygrowthfinancialservices.com Use term = 18 months
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  Discount 13 • Discount onshare purchase at time of conversion to stock • Compensates early investors for greater risk • 20% is standard • Recent trend in Silicon Valley toward 15%, 10%, 0% discount www.seedchange.com www.earlygrowthfinancialservices.com Use 20%
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  Convertible note cap 14 •Dilution protection, not company valuation • Allows conversion to stock at a ratio guaranteed not to fall below $_____ • Aligns incentives between investors and founders • Investor chooses to convert using either note cap or discount – not both Median note cap = more or less approx. something like $4.5 million www.seedchange.com www.earlygrowthfinancialservices.com
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  Conversion example #1 15www.seedchange.comwww.earlygrowthfinancialservices.com Assumptions: Note converts after equity investment of $1.5m. Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion. Assumes no post-money option pool (the last worksheet adds an option pool to this scenario) Company (pre-funding): DISCOUNT CAP Shares outstanding* 8,500,000 Series A at conversion Series A at conversion Effective valuation $3,781,250 Effective valuation $3,925,000 Convertible note terms: Share price $0.44 Share price $0.46 Note Size $575,000 No. of shares 3,371,901 No. of shares 3,248,408 Note Cap $4,500,000 Equity 25.00% Equity 25.00% Note Discount 20% Note Holder at conversion Note Holder at conversion Series A terms: Share price $0.36 Share price $0.46 Series A investment $1,500,000 No. of shares 1,615,702 No. of shares 1,245,223 Series A valuation $4,500,000 Equity 11.98% <----- Equity 9.58% Return 1.25x Return 1.00x Note holder converts via DISCOUNT -----> CONCLUSION At this Series A valuation, the note converts using the DISCOUNT, creating 2.4% more equity for the note holder compared to a CAP. The note holder's return on the Series A is 1.25x. Cap Table (Ownership) shares % Team 8,500,000 63.02% *Shares issued to founders and employees Series A 3,371,901 25.00% Note holder 1,615,702 11.98% 13,487,603 100.00%
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  Conversion example #2 16www.seedchange.comwww.earlygrowthfinancialservices.com Assumptions: Note converts after equity investment of $1.5m. Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion. Assumes no post-money option pool Company (pre-funding): DISCOUNT CAP Shares outstanding* 8,500,000 Series A at conversion Series A at conversion Effective valuation $12,781,250 Effective valuation $11,775,000 Convertible note terms: Share price $1.50 Share price $1.39 Note Size $575,000 No. of shares 997,555 No. of shares 1,082,803 Note Cap $4,500,000 Equity 10.00% Equity 10.00% Note Discount 20% Note Holder at conversion Note Holder at conversion Series A terms: Share price $1.20 Share price $0.46 Series A investment $1,500,000 No. of shares 477,995 No. of shares 1,245,223 Series A valuation $13,500,000 Equity 4.79% -----> Equity 11.50% Return 1.25x Return 3.00x Note holder converts via CAP -----> CONCLUSION At this Series A valuation, the note converts using the CAP, creating 6.71% more equity for the note holder compared to a DISCOUNT. The note holder's return on the Series A is 3x. Cap Table (Ownership) shares % Team 8,500,000 78.50% *Shares issued to founders and employees Series A 1,082,803 10.00% Note holder 1,245,223 11.50% 10,828,025 100.00%
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  The down sidesof convertible notes (and an alternative) 17 • It’s still debt—and investors really want equity • Debt incurs interest—and investors really don’t care • Debt has to be repaid---but what if you can’t? Why not create something that looks and acts more like stock? Someone did: SAFE (Simple Agreement for Future Equity) www.seedchange.com www.earlygrowthfinancialservices.com
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  Q&A and ThankYou! Kevin Smith 415 Jackson Street San Francisco, CA 94111 www.seedchange.com [email protected] 1.877.711.9883 @seedchange Gadiel Morantes www.earlygrowthfinancialservices.com [email protected] 415.234.3437 @EarlyGrowthFS SEEDCHANGE