Why Do I Care?
Not all startups have hockey-stick growth. There are numerous paths to profitability and traction:
- Some need to scale.
- Some need to pivot.
- Some simply need to start over.
Convertible notes are a form of funding that caters to this exact market segment of startups – they yet show promise, but are in need of capital to continue growing. Perhaps most importantly, convertible notes typically occupy the lower end of investment that venture capital firms don’t consider worthwhile.
How do they work?
A convertible note is an investment made by an angel investor to a startup. It technically functions as a loan, but the startup repays the investor with preferred stock at a discount upon a Series A investment round, instead of the principal amount lent. This is best illustrated with an example:
Angel signs a $100,000 convertible note with Fundco. The terms of the note state that Angel will receive a 20% conversion discount upon a qualified financing round, such as a Series A investment round.
Fundco closes a $1,000,000 Series A investment round from VCFirm, and each share is valued at $1.00 per share.
Since this Series A round constitutes a qualified financing round, Angel’s initial investment of $100,000 will convert into $100,000 worth of preferred shares plus the 20% discount.
The question then becomes how many shares $100,000 can buy at $.80 per share, which is the discounted price. This turns out to be 125,000 shares. Thus, Angel is rewarded by taking the risk and investing early in Fundco.