Three Key Terms
The conversion discount is the most important aspect of a convertible note. As demonstrated above, it gives the investor an opportunity to see a real return on investment in exchange for investing in a startup that may not have gained traction yet. Discounts are typically anywhere from 10-40%, and are determined by a host of factors such as:
- The angel investor’s reputation.
- The startup’s initial and potential traction.
- The startup’s leverage by competition between angel investors.
- Overall market conditions.
The maturity date is when the convertible note becomes due and payable in full to the investor. It essentially sets a deadline for the conversion discount to apply, and once the deadline passes, the investor just wants his principal investment back. However, the vast majority of convertible notes are not secured with collateral, like a typical business loan.
So what actually happens when a convertible note matures? Usually nothing.
Each party involved is aware of the hit-or-miss nature of these investments – arguably, the investor doesn’t always expect to be paid back. And as a practical matter, if the company is out of money, what is recoverable?
A valuation cap institutes an upper limit on the valuation of the startup in regards to the investor’s conversion discount. The higher the startup’s valuation for a qualified financing round, the fewer shares the convertible note purchases. Therefore, a valuation cap assures the initial investor a decent return on investment. Let’s return to Fundco for an illustration:
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. In addition, there is a $500,000 valuation cap.
Earlier, this amounted to Angel owning 125,000 shares of converted preferred shares. However, the Series A round is greater than the valuation cap.
To determine the new share price for Angel, we divide the valuation cap by the Series A valuation ($500,000 / $1,000,000) to get $.50 per share.
At $.50 per share, the initial $100,000 will buy 200,000 shares. This is quite a windfall as compared to Angel’s take without a valuation cap.