- So, when you raise convertible debt, and have what's called a convertible note as part of it, there is an expectation that some time in the future that note is going to convert into equity, and typically it's the next equity financing that you do. As part of that equity financing, the convertible note often has some features associated with it that result in the convertible note investor getting something slightly different in the future than they would have gotten if they'd simply invested in that future equity round.
The most significant of these features is usually called a discount, and the essence of a discount is it gives the convertible debt holder equity, but at a discounted price. So, if for example, the financing gets done and your valuation is a $20 million valuation, and the convertible note holder has a 20% discount, they're effectively getting a valuation of a $16 million valuation instead of 20, or if you want to use price per share as a metric, if your price per share is two dollars, they're getting a price per share of $1.60, which means that they get more stock.
Now, there's a lot of complexity around the discount that emerges, especially as convertible debt rounds have become more like equity. One of the ones that pops out a lot is this idea of a liquidation preference. And a liquidation preference is very complex in the context of the different flavors of it, but one of the things that it's important to recognize is that most liquidation preferences are linked to the amount of capital that you raise. So if you raise $5 million, and it has a liquidation preference, the liquidation preference will be linked to that $5 million.
But what happens if you're raising that $5 million, and it's off of a convertible note with a 20% discount? Well, that 20% discount on the convertible note means that the $5 million is effectively going to have an extra million dollars of equity associated with it, or $6 million, so it looks like the investor invested $6 million into the round instead of five, but the company still only got $5 million in cash. So figuring out how to to manage that has become an art that in a lot of ways makes convertible debt financings more expensive, or more complicated than equity, or are situations where lawyers, or when the note gets created in the first place, don't consider or really contemplate what needs to be done with it.
Another feature of convertible debt financings that's really important to pay attention to is the conversion cap. So, in that moment where the debt converts into equity, understanding what the cap is on the convertible note will determine the maximum valuation that the note holder gets. So if you do a $20 million financing, but you have a note outstanding with a cap of $10 million, that ends up looking like a 50% discount for that note holder. So in the context of convertible note financing, there's a lot of little nuances that have a lot to do with what equity actually goes to the note holder.
The last thing to consider is the length of time that the note's outstanding, and how the note behaves when that timing is up. Most convertible notes have a 12 month term on them, and after 12 months, the investor usually has some rights. They can renew the note, they can retrade the note, they could demand repayment to the note. They could convert the note into earlier rounds of equity. So when you're negotiating the note, understanding what these characteristics are can have potentially a lot of impact on your capitalization downstream.
- Exploring potential stakeholders: friends, family, and more
- Finding a venture capital firm
- Breaking down the term sheet
- Taking on debt
- Asking for NDAs
- Accepting a no