A convertible promissory notes (or convertible debt) is a financial instrument, which is by nature a loan made by an investor to a company. Unlike a conventional loan, the convertible notes is repaid with the startup’s equity. However, it is less likely that venture capital funds (and some angel investors) would prefer this financial instrument given that they may wish to they seek additional control provisions, e.g. voting rights, board representation, so as to better safeguard their investment interests.
A convertible promissory notes is convertible in the sense that it could convert the debt to equity when the company does the next round of equity fundraising. As an investor investing in such a high-risk business, he might dictate that the conversion might take place only upon the satisfaction of certain minimum thresholds, e.g. 1-2 time(s) of the principal amount.
A valuation cap is the maximum effective valuation that the owner of the notes will pay, regardless of the valuation of the round in which the notes converts. It is a common tool for founders and startups to incentivise and reward investors to take on more risks in early-round financing. Essentially, a valuation cap is the projected highest price or the price ceiling at which the convertible notes could be converted into equity. This gives investors greater assurance that they could at least gauge the “floor” of the equity they could acquire in the next round, i.e. Series-A fundraising.
For example, in the next round of fundraising, if the investor has invested $100k in the seed round (assuming that no discount and interest would be given), the pre-money valuation is $10m, but the valuation cap is $1m, then the pre-determined valuation cap in the seed round (which is the lower of the two) would apply in calculating the pre-money conversion share price, and the investor could acquire 10% instead of 1% of the shares in the startup.
In a convertible notes, a discount rate might be given by which the share price in later equity financing is discounted. Like a valuation cap, it is to reward investors for taking on risks in earlier financing. A discount rate defines a lower effective valuation via a percentage off the round valuation. Investors see these as their seed “premium”.
For instance, assuming that the discount rate is 20% and the pre-money conversion share price is $5 per share, by the time when the convertible notes is converted to equity, early investors would enjoy a 20% discount on the pre-money conversion share price available to other investors, so the early investor in effect only needs to pay $4 for each share. Then, the early investor could acquire 25% more shares than he does without being given a discount.
Similar to conventional loans, convertible notes is a debt in nature and it comes with a maturity date. Having a maturity date better protects investors in the sense that it incentivizes startup to secure the next equity financing round happens.
That being said, the startup in question still runs a chance that it might be acquired before the convertible notes matures, or the startup does not engage in another round of equity financing. If that is the case, investors would not be pleased with the returns even if they could get 100% of their investment back because what they lose also includes the opportunity cost of foregoing an alternative investment that might have a higher return. To safeguard investor’s interest, many convertible notes may also adopt a multiplier in their standard payout terms.
In the event that the startup defaulted on the convertible notes and failed to repay the required amount by the maturity date, subject to the terms of the agreement, investors might opt to force the startup into liquidation, which would be a lose-lose situation because they might not get their investment back as well. As such, it is also possible that investors might extend the maturity date and leverage the extension to negotiate for a more considerable discount or a lower cap.