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If you’ve made it this far, welcome to Chapter Two!

Over the next few weeks, we will focus on convertible notes, SAFEs, liquidation preferences, and share classes.

Also quick shoutout to some friends who crush it:

My friend Andrea who runs CPGD. CPGD is a great resource to stay up to date on new brand launches and news. Their weekly newsletter is read by over 10,000 founders and investors.

My buddy Kyle who launched Paperboy Ventures. He brings on interesting emerging brand founders to pitch their ventures and recently launched a useful job board for talent searches.

Priced vs. Non-Priced Rounds

We previously discussed approaches to valuation (DCF, comp analysis, etc). Remember that in a “priced financing,” VC(s) and founder(s) reach an agreed upon valuation for a company that equates to a specific price per share at which stock will be sold to purchasers (VCs, angels, etc). Priced financings often require execution of a myriad of legal documents (we discussed the long form closing documents in our first post) that are timely and costly.

Not all venture financing involves setting a specified valuation. Convertible notes and SAFEs are referred to as “non-priced” rounds because they do not explicitly set a share price and thus do not have an associated pre-money valuation. Instead, the share price is a function of a future priced financing round that triggers conversion of convertible notes or SAFEs into equity. We will dive into the mechanics of that conversion process today (which centers around terms we will define in detail such as valuation cap, discount, qualified financing, and more). Non-priced financings typically enable founders to raise money more quickly with less legal expenses - convertible notes and SAFEs are simple to document compared to priced financings.  

What is a Convertible Note?

Let’s break down the two word phrase: Convertible Note

1) Starting with “Note” - indicates a form of debt, like a loan

2) Then “Convertible” - indicates that the debt is convertible into an equity-like security

Taking these two together: a convertible note is a debt instrument that can be converted to equity based on the occurrence of certain events (most commonly during a priced equity financing round).

With debt, like a loan, you don’t technically have to argue about valuation… this also holds true for convertible notes except that you may argue about future potential valuations scenarios using the concept of a valuation cap, which we will discuss in detail.

Convertible Notes are frequently used to finance pre-seed, seed, and early stage companies (when defining valuation is more subjective). Sometimes you will see a convertible note used for a later stage company. This often occurs when investors agree to provide temporary financing to secure a company’s cash balance before the company raises their next priced round. This concept is often referred to as “bridge” financing aka the bridge that gets you to your next priced round.

Unlike a bank loan or secured debt instruments, a convertible note is typically not secured by the assets of a company. Further, because a convertible note is debt, it is generally considered senior to equity holders (founders, prior investors, etc) in the business. Thus, if there was bankruptcy before a convertible note converted to equity, noteholders would sit junior to a secured lender but senior to equity holders in terms of getting their investment back depending on bankruptcy liquidation proceeds.

Full credit to Ilya Strebulaev, Rob Siegel and Anne Beyer from GSB for several of today’s charts.

Key Terms Part #1: Debt Repayment Terms

Terms associated with convertible notes can largely be split into two categories.

1/ Debt repayment terms: defines specifics associated with principal, interest rate, maturity date, and default provisions.

2/ Equity conversion terms: defines the specific event(s) that triggers conversion of debt to equity, the formula used during conversion (considering the impact of the valuation cap and/or discount – to be discussed), the type of equity received upon conversion by the note holder (common vs. preferred equity), and any associated rights the new equity holders will get after their convertible note is converted to equity (voting, dividends, etc).

Debt Repayment Terms:

1/ Principal: the amount of investment provided by the noteholder (investor) to the company through the convertible note. In an unfortunate scenario where the note never converts to equity (we will discuss this), the principal (plus any accrued interest) is what the company owes the noteholder (unless nuanced legal terms dictate otherwise). Assuming the note does convert to equity (the norm), the principal (plus any accrued interest) is the quantity used to calculate how many shares the note holder will receive upon conversion into equity.

2/ Interest Rate & Payments: convertible notes often feature interest rates. Unlike a traditional loan, startups rarely pay the interest in cash to the convertible noteholder periodically. Instead, convertible notes accrue interest until the time of conversion.

For example, if a VC invests $750,000 in principal with a 10% annual interest rate via a convertible note on 1/1/2025. Each month, the total value of the investment will increase in value by $6,250 (= $750,000 x 10% / 12). If the convertible note hypothetically converts on 1/1/2026, it will convert with $825,000 worth of value. As exemplified, convertible notes are typically structured on an “accrual basis” in regards to interest payments as opposed to the startup dishing out $6,250 in cash back to the noteholder each month.

Interest rates for convertible notes typically span from 5% to 12% with ~8% typically serving as the average:

Maturity: the date at which the debt (plus any accrued interest) is due for repayment. This is typically 12, 18, or 24 months from the issuance of the convertible note. We will talk about conversion momentarily but the norm for a convertible note is that it has converted into equity prior to the maturity date.

If the convertible note hasn’t converted to equity by the maturity date (or had a repayment triggered pursuant to a change in control), the next steps are dependent on contractual/legal terms dictated in the convertible note legal docs that were previously signed. This scenario can be easily solved or can get potentially complicated/nasty… we will discuss in more detail.

For starters, some convertible notes have specific terms that dictate automatic conversion into equity at maturity or entitle the noteholder to an optional conversion into equity if the note is still outstanding on maturity.

A common alternative to repayment is for the company and noteholders to agree to an extension on the maturity date of the note. We will discuss why this is generally rational for all parties.

Lastly, if the company is unable to pay the note at maturity (doesn’t have the cash) and a maturity date extension isn’t reached (and investors don’t automatically or voluntarily convert), investors as debt holders can pursue a liquidation/bankruptcy process for the company (this is what we mean when we say things can get nasty). Sitting senior to existing equity holders, convertible noteholders will be privileged to liquidation proceeds before equity holders.

Prepayment: payment of the principal and accrued interest by the startup before the note matures. This is quite rare. We will discuss when this can come into play later. This is generally only allowed if there is a majority of supermajority vote in favor of prepayment by the noteholders. Furthermore, a convertible note investor may ask for a clause called voluntary conversion, which gives the investor the power to convert into equity whenever desired (even before maturity) under specified details, negating any prepayment potential (we will also discuss - this can be a very important term).

Equity Conversion Terms

While debt repayment terms are relatively straightforward (resembling typical debt), equity conversion terms are more VC-specific and a little trickier.

Conversion: convertible notes automatically convert into equity if certain triggers occur. The most common trigger that leads to the conversion of a convertible note into equity is a priced equity financing round. The round size of the equity financing typically must meet a certain dollar threshold to be deemed a “qualified financing” and trigger conversion.

Conversion takes place into the equity type issued in the qualified pricing – aka if you are a convertible noteholder and you are converting into equity during a Series B qualified financing, you will typically be awarded equity in the form of Series B shares. The Series B shares awarded to convertible note holders may or may not share the same legal rights as the new Series B investors (i.e., voting rights, liquidation preference, etc). The norm (and what a founder should pursue) is that the liquidation preference for the conversion shares matches the conversion price, rather than the liquidation preference for the new, full-price shares.

^{Typical clause: “In the event that Payor issues and sells shares of its equity securities to investors (the “Investors”) on or before [180] days from the date herewith (the “Maturity Date”) in an equity financing with total proceeds to the Payor of not less than $2 million (excluding the conversion of the Notes or other debt) (a “qualified financing”), then the outstanding principal balance of this Note shall automatically convert in whole without any further action by the Holders ….”}

A second very common conversion trigger is a change in control (i.e., M&A) or a liquidation event (i.e., IPO). It’s important as a founder to address how debt will be handled in the context of an acquisition during legal negotiations with prospective noteholders.

In such a case, the convertible note is:

1/ typically automatically converted into equity (prior to the change in control), often at the valuation cap)

OR

2/ repaid at the greater of the principal plus interest vs. the value of the conversion amount vs. a multiple on the principal.

As previously mentioned (see explanations in maturity section above), in the absence of a “trigger event” combined with the arrival of the maturity date, there can be automatic conversion, optional conversion, voluntary conversion, repayment, a maturity extension, or a default on the debt.

Now let’s discuss the terms that determine the conversion price the noteholder receives when converting into equity.

Discount: a discount is a term awarded to the convertible noteholder that drives a reduction in the conversion price per share that they are awarded during a qualified financing. Discounts typically range from 10-30% with 20% being the most common.

Example: imagine a convertible noteholder is given a 20% discount for a $400,000 investment (10% interest rate for simplicity). A year later, the company raises a qualified Series A at $4.00/share. Exercising their discount, the noteholder would get the benefit of receiving the equivalent of $3.20/share (a 20% discount to $4.00/share). The noteholder would thus be rewarded with 137,500 shares = ((400,000 x 1.1) / 3.20).

The idea behind the discount is that early investors should:

1/ be rewarded with more upside for the risk that they are taking by investing earlier than future investors that participate in an upcoming qualified priced financing

2/ get compensated for the time value of money

^{Typical clause: “This Note shall automatically convert in whole without any further action by the Holders into such equity securities at a conversion price equal to 80% of the price per share paid by the Investors purchasing equity securities on the same terms and conditions as given to the Investors.”}

Valuation Cap: a valuation cap is an investor favorable but very common term that puts a ceiling on the conversion price at which a convertible note would convert into the equity security sold at the qualified financing.

Noteholders are frequently provided a valuation cap as protection against runaway valuation growth prior to conversion that outstrips the risk taken by the investors (as, in that case, a discount would be deemed insufficient return for the risk). The valuation cap is a ceiling conversion valuation. For example, if a valuation cap is $10 million, then the conversion price is based off of a $10 million valuation, regardless of whether the valuation in the qualified financing is $20 million, $200 million, or $2.0 billion.

As an investor, you want the valuation cap to be as far below the valuation in the future qualified financing as possible (this facilitates a lower conversion price during the qualified financing and thus more awarded shares/equity). Conversely, as a founder, the closer the valuation cap is to the valuation in the qualified financing, the less you will be diluted (as the noteholders will receive a less favorable conversion price). Valuation caps can be set on a pre or post money basis – specifically a noteholder may be given their cap on a pre-money basis, which means that they’d have the right to a certain pre-money valuation equivalent conversion price. Same idea for post-money. Generally speaking, post-money valuation caps are more investor friendly because they provide certainty on amounts owned post-conversion. This is because the dilution resulting from any subsequent convertible securities would, if a post-money valuation cap applies, be borne solely by the existing equityholders (usually founders) and not proportionally by the investor.

All of this sounds a bit confusing… and it is. The video example below should help clear the air on how all of this comes together.

A rambling perspective: “technically” you are not determining the valuation of a company by establishing a valuation cap as no real price per share is being set…. but noteholders are essentially establishing what valuation they believe they deserve in the future based off where the business is today with a cap… thus as an investor, setting a valuation cap is very much like setting the valuation of the company. Daniel negotiates valuation caps with the same logic that he uses to negotiate valuation in priced rounds. This is ironic because the main purpose of convertible notes is to punt the valuation discussion for the future qualified financing.

Simple example: let’s say a company has 1,000,000 fully diluted shares outstanding. A noteholder invests $400,000 on a convertible note with $10M pre-money cap. This means that the capped price per share is $10,000,000 / 1,000,000 = $10/share.

What can we take away heading into the qualified financing?

• $10/share is the maximum (the ceiling) price per share the noteholder when converting into equity

• If the price per share for the future qualified financing comes in anywhere above $10/share, the noteholder will get the benefit of a conversion of $10/share (a discount to what the new investors are paying).

• If the price per share for the future qualified financing comes in anywhere below $10/share, the noteholder will get the benefit of a conversion equal to whatever price the new investors are paying (a price below $10/share).

  • Note: In this case, the noteholder overpriced the business when setting the valuation cap.

In the sections above we’ve given examples in which a noteholder has a discount OR a cap.

Important: convertible notes often feature both conversion discounts and a valuation cap. The price per share exercised by the noteholder (the ‘conversion price’) is the lower of the discounted per-share price in the next qualified financing or the per-share price implied by the valuation cap (‘the capped price’).

_{Typical clause: “Conversion Price shall equal the lower of (A) 80% of the price paid per share for Equity Securities by the investors in the Next Equity Financing or (B) the quotient resulting from dividing (x) $4,000,000 by (y) the number of shares of outstanding common stock immediately prior to the closing of the Next Equity Financing (assuming conversion of all securities convertible into common stock, exercise of all outstanding options and warrants […] but excluding the conversion of these Notes).”}

In the above example, let’s say we add that the noteholder also has a 20% discount in addition to the $10M pre-money cap and will choose to exercise the term that generates the most favorable conversion price.

With this knowledge we can conclude what I call the indifference point aka the price per share at which the noteholder is indifferent between exercising the discount or valuation cap. In the example above the indifference point is $12.50 per share = ($10.00 / (1-20%)).

What can we take away heading into the qualified financing?

• If the price per share of the future qualified financing is > $12.50/share, the noteholder will exercise the cap of $10/share. The 20% discount multiplied by any price per share > $12.50 will result in a conversion price per share > $10.00. Thus, it is in the noteholders’ best interest to exercise the capped price of $10.00 to receive the lowest possible conversion price per share.

• If the price per share of the future qualified financing is < $12.50/share, the noteholder will exercise the 20% discount. The 20% discount multiplied by any price per share < $12.50 will result in a conversion price per share < $10.00. Thus, it is in the noteholders’ best interest to exercise the discount to receive the lowest possible conversion price per share.

All the scenarios below are feasible:

Uncapped Notes

These are a big “NOs” in our world except for in extremely rare circumstances. By participating in an uncapped note, you are limiting the benefit you deserve to receive for the risk that you are taking as an early stage investor (especially if the note is uncapped AND without a discount - as an investor, this translates to literally setting yourself up to get zero benefit for the risk you are taking as you are guaranteed to receive the same price per share as the investors in the future qualified financing).

Imagine an investor wants to invest 100,000 in a company and thinks the pre-money valuation is somewhere between $2M-$3M. The founder thinks the valuation should be higher and convinces the VC to invest in a note with a 20% discount without setting a valuation cap. A year passes and the company is doing quite well. The founder receives a term sheet at a $20M pre-money valuation. In this case, the investor is awarded the equivalent price per share of a $16M valuation (a 20% discount on the price per share in qualified financing). While the investor is happy for the entrepreneur, absence of a $2M-$3M cap during the note construction punished the VC with a much worse resulting conversion price per share. This is the risk of failing to set a cap.

So why would an investor agree to signing a note in the absence of a cap or the absence of a cap or discount. Honestly, we don’t recommend it but there are a few unique circumstances that may warrant this for some VCs:

Essentially this might occur if a VC is so obsessed with investing in a hot company or a legendary founder that he or she doesn’t care about pricing.  

• The founder is so proven that he or she can convince people to participate under any circumstances. Imagine if Sam Altman asked if you wanted to be his first money as an angel on an uncapped note for his newest company. It might be tempting.

• The VC may feel that the future round of financing will be so competitive that he or she won’t be able to win allocation. The investor may throw an uncapped note in front of the founder prior to the round just to guarantee that at least he’ll have some money convert in the next round.

• In a similar vein, a VC may meet a founder shortly before the founder is planning to raise his or her round. Slipping in a convertible note with a discount before the round commences could be a win.

Convertible Note: Video Simulation 

Convertible Note Simulation (Final) - Watch Video

Pros and Cons of Convertible Notes

Dangers of Convertible Notes for Founders

A common mistake that we see founders make is raising too much convertible debt in the early days of the company.  This can lead to giving away too much equity to outside investors as founders fail to properly anticipate the severity of the future dilution.

Why does this happen?

As discussed, a main feature of convertible debt is that it enables founders to raise capital quickly and with less legal expense than equity financings. As a result, convertible debt financing often has multiple rolling closes (unlike equity financing with a single close).

A founder who may have targeted raising $2M on a convertible note decides to let other investors in on the note over time since more money feels better than less money – and it’s not challenging to keep processing new investors legally. The founder heads to their priced financing round with $3M-$4M in notes pending conversion. While the notes may have valuation caps and/or discounts, the actual conversion price is not known until the qualified priced financing occurs.

We’ve witnessed several cases in which the founder is surprised to see that he or she has sold much more equity than expected at the close of the priced round. Not only is this upsetting to the founder, but it can also worry the new investor(s) in the priced round. The new investor(s) wants the founder to feel motivated based off their equity ownership position after closing. With too little ownership, the founder may become demotivated – this tension may require the investors to get creative with allocating options and equity grants to the founder in the future at the expense of potentially diluting themselves.

Unique Conversion Scenarios: The Argument for Maturity Extension

What if a company fails to land a qualified financing before the maturity date? This happens all the time. Given the convertible noteholders’ interest in owning future preferred equity in the company, it’s typically sensible to extend the expiration date on the note.

Why?

1) Investors want to see a gain on their investment via future financing and this buys more time (they also accrue more interest on top of their principal!).

2) The company is unlikely to have robust valuable assets or cash flow if the investor forecloses & demands repayment of principal + accrued interest - plus the investor would rack up legal fees.

3) Reputation travels. A founder in Daniel’s network had an investor take legal action, demanding principal repayment on an expired note at a time when the startup had limited cash or liquid assets on the balance sheet. Let’s just say not a good look for this investor as a future partner to founders. 

Unique Conversion Scenarios: The Importance of Voluntary Conversion for VCs

Voluntary conversion kicks in rarely but is quite important:

In 2020, Daniel witnessed a startup raise a $2M convertible note at a relatively low valuation cap (~$10 million). The company was already experiencing strong growth and profitability dynamics; however, after closing the note, the company 7x’d their revenue run rate in ~18 months and began generating material cash flow.

With the convertible note expiration date approaching, the company didn’t need to raise a priced round anytime soon and had an ample cash position to pay back the principal and accrued interest on the convertible note. The founders knew that the company had a paper valuation much higher (~$115 million) than that of the valuation cap (~$10 million) on the convertible note. Thus, any future qualified financing would lead to material dilution for the founders due to the conversion of the note at a heavily discounted price per share.

So, the founders emailed their convertible note investors, intending to pay the investors their principal and accrued interest back (aka prepayment) – instead of allowing it to ever convert to equity.

In the absence of a voluntary conversion clause or voting structure to prevent this, this is a nightmare scenario for the convertible note investors as they’re potentially missing out on a 10x + markup. The founders are thrilled. Besides potentially burning a few bridges with VCs, they are avoiding the material dilution that would come with the conversion of a note that was issued at a $10 million valuation cap.

A voluntary conversion clause provides an investor with the ability to voluntarily convert their convertible note into equity even if the conditions for automatic conversion haven’t been met. In the case of our example, the voluntary conversion clause stated that:

“If a qualified financing or triggering event does not take place prior to the convertible note’s maturity date, investor x has the right to voluntarily convert their convertible note into preferred equity at the lower of the pre-money valuation driven by the valuation cap or the pre-money valuation of the most recent historical financing.”

AKA: you as the investor have the right to get equity in this company at a super low valuation even though an event to trigger the conversion of your note hasn’t occurred.

In the case above, the voluntary conversion provision protected investors by giving them upside if the startup didn’t need to raise a future equity offering after raising the note.

Thus, the convertible note investor class let out a huge sigh of relief and responded “thanks, but no thanks” to the founders attempt to repay the principal and prevent conversion to equity.  

In theory, early stage note investors should at a minimum be rewarded with preferred equity for taking on a high level of early-stage risk. So, while the founders will now experience more dilution, it doesn’t feel totally unfair.